Bill Simmons is the head US interest rate portfolio manager for Cannon. Simmons believes that 2-year rates will remain stable while all other rates in the yield curve will rise by 50 bps.
John Rucker, a member of Cannon’s investment committee, agrees with Simmons’s view for interest rate levels but also believes that interest rate volatility will likely rise in the coming year. Rucker wants to use derivatives to capitalize on the out-of-consensus view and asks other members of the committee for ideas that could generate positive excess returns for clients.
Given Rucker’s outlook, which action is least likely to generate excess portfolio returns?
A. Short a payer swaption on a 10-year rate.
B. Long a call option on a 5-year futures contact.
C. Long a put option on a 10-year futures contract
Short payer swaption clearly will not generate any returns, but neither won’t the long call, no?
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The long call will benefit from rising volatility. Even though the rate will rise putting downward pressure on the futures contract price (OTM call territory), it should be compensated for (somewhat) by the increased volatility of the rates in general. The classic ‘least likely’ 
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ahh 
the volatility argumented slipped my mind… thanks!
Tim Salmon is another portfolio manager at Cannon who is responsible for managing
the firm’s treasury portfolios with remaining maturities of two years or less. Salmon
believes that front-end rates will fall as a result of accommodative monetary policy but is
unsure on the direction of market volatility. Given the constant daily flows in his
portfolios, Salmon is extremely focused on liquidity.
Given Salmon’s outlook on the level and volatility of front-end interest rates,
which strategy is most likely to result in higher returns, while maintaining liquidity
in his portfolio?
A. Buy 1-year bonds with a call option.
B. Buy 1-year bonds with no embedded option.
C. Go long a 1-year pay-fixed interest rate swap.
B
Buying 1-year bonds with no embedded options is most likely to result in higher returns given Salmon’s view for lower front-end rates. Answer Choice (A) is incorrect because the call option will limit the return upside if the 1-year rate falls and liquidity is likely to be higher for bonds with no options. Answer Choice (C) is incorrect since going long a pay-fixed interest rate swap will result in negative returns if rates fall.
Ahh maaan, come on 
front rates (short-term rates fall), so an option-free bond actually underperforms a bond with a call option, which does well when rates fall and the underlying increases? I think the explanation lies in the fact that the call option “belongs” to the issuer, so he’s the one benefiting in such a scenario, not you as a buyer?
A callable bond will not benefit the buyer in a decreasing rate environment because capital gains are capped at the strike. So there is less upward potential for a callable bond than for an option free bond when rates go down. Option free bond will outperform callable bond when rates decrease.
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Of course… the option-free bond will increase MORE in value.
I must be super tired, cannot even see the obvious…
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