If you think short term rates will fall and long term rates will rise over the next 12 months, what yield curve strategy would most likely realize the highest profit:
- a carry trade.
- a bullet structure.
- duration management by buying long-term bonds.
This question is from reading 24 eoc #7.
Why is A not the right answer?
Section 3.1
When YC to remain stable no change in level, slope or curvature…the 4 things to do etc… Carry trade is one of them. Now with short term rates falling and long term rate rising is that a static/stable YC?
bullet is the most resistent to non-paralel shifts.
carry trade only when YC is stable.
Assuming a normal (i.e., upward-sloping) yield curve, how would you implement a carry trade?
Yield Curve steepening --> Bullet (long bonds will perform more poorly than short bonds will perform well since their duration/interest-sensitivity is higher, so you’re better off being in 10-15 yr maturity bonds)
Flattening --> Barbell
Why does the curve have to be stable. If you short a bond future, and yield increases then you gain.
You aren’t looking at the overall picture right now. If you anticipating YC to be stable/static you go with a certain set of strategies. If you expect slopes, levels and curvature you go with other strategies such as duration management. Which is going with bullets are barbells and buying convexity.
Okay so lets break it down. Since ST rates are decreasing while LT rates are increasing. That means price is going to go up for ST and price will fall for LT rates.
So multiple choice.
A: We aren’t going to go with a carry trade curve because yield curves are not stable or static. Carry trades work in stable non volatile environments. If there is any volatility I think the book references picking up nickles in front of a Zamboni or something.
B: Now of course a bullet would do best because you’d be in the center with 5, 10, 15. If you go even further in the back of the reading they’ll say you’d want to do a short butterfly where you’d short the wings and long the body. Which is long the bullet and short a barbell.
C: Now C is obviously incorrect. You’d be buying when i increases and price falls at the long term rate.
If you still don’t understand I’d recommend you read 3.1 and compare it to section 3.2.
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What if you’ve put on a carry trade in a in upward sloping curve environment, and the long end increases while the short end of the curve decreases, wouldnt that benefit the trade (borrowing cost down while rates where you invest go up)?
How, exactly, have you put on a carry trade? What were the transactions?
You borrow in the short end and invest in the long end, e.g. short 3m and go long 10y gvt bonds
What, exactly, is the transaction to “invest in the long end”?
I need you to see the specifics here, so that you, ultimately, can answer your own question.