R20: Yield Curve Strategies

Question 1

What are the strategies if YC stable?

Answer 1

Buy and hold
Ride the YC
Sell convexity
Carry trade

Question 2

What are the strategies if YC changes?

Answer 2

If parallel shift:
Duration management
Buy convexity

If non-parallel:
Barbell/bullet

Question 3

When buying convexity, what do rates need to do?

Answer 3

Change quickly or the high convexity will be a drag on yields which may outweigh expected price effect

Question 4

When does a bullet outperform a barbell?

Answer 4

When YC steepens

Question 5

How do you calculate the spread of a butterfly? What are the positions if you’re long and when should you be long?

Answer 5

Spread = 2 × Med Y - ST Y - LT Y

Long barbell, short bullet 》duration neutral

Long butterfly if you expect the spread to increase. When yield steepens at short end and or flattens at long end. Duration neutral so immunised against parallel shifts.

Question 6

What’s a condor?

Answer 6

Like a butterfly but extra Med position, higher convexity.

Profits if YC steepens at ST and flattens at LT like a butterfly. Duration neutral so immunised against parallel shifts.

Question 7

How can you add convexity with options? And reduce it?

Answer 7

Use options to add convexity but this will massively increase duration so sell long-term bonds to fund call option and sell more to reduce duration further to original levels. Then put into cash.

To reduce convexity:
Sell options
Buy MBS
Buy callable bonds 
Sell putable bonds

Question 8

What are the characteristics of an inter-market carry trade?

Answer 8

Assume uncovered risk parity doesn’t hold.

Negative skew and fat tails.

Question 9

What strategies could you use for intra and inter-market carry trades?

Answer 9

Intra:
Buy bond and repo
IRS - receive fixed, pay floating
Long bond future

Inter:
Borrow low r currency, convert in high r and buy bond
Currency swap - receive payments in high r, make payment in low r
Borrow high r, buy bond, FX forward to convert into low r