Reading 20: Yield Curve Strategies

Question 1

Active Yield Curve Strategy

Answer 1

When a manger invests in a portfolio of bonds with a higher duration than the portfolios benchmark to earn a higher yield. Different to riding the yield curve where a manager expects price appreciation to enhance returns.

Question 2

Intermarket Carry Trades

Answer 2

The likelihood of an intermarket carry trade generating a profit is relatively high. However, the distribution of returns is both fat-tailed and negatively skewed, meaning that when losses occur, the losses are likely to be large.

Question 3

Duration-Neutral Strategy

Answer 3

The optimal duration-neutral, currency-neutral carry trade is achieved by lending long/borrowing short in the steepest market and lending short/borrowing long in the flattest market.

Question 4

Butterfly Strategy

Answer 4

A butterfly that is long in the wings and short in the body has net positive convexity. Regression weighting uses regression analysis to derive the weightings of the wings of a butterfly, taking into account the difference in yield volatilities at the short and long ends of the yield curve.

Question 5

Portfolio Convexity

Answer 5

In order to increase portfolio convexity, you want to increase exposure to long put options (increase putable bonds) and decrease exposure to short call options (decrease callable bonds and mortgage-backed securities). Higher convexity equals lower yield, so search for convexity when interest rate volatility is high.

Question 6

Riding the Yield Curve

Answer 6

Effective when targeting portions of the yield curve that are steep and will remain relatively constant.

Question 7

Bullet

Answer 7

A bullet performs well when the yield curve is expected to steepen, insulating against long term rises and giving up little short term decrease yield profits due to low duration at that end.

Question 8

Convexity

Answer 8

Buying options (put or call) increases convexity, in anticipation to large changes in rates. If the rates remain constant, there will be a loss due to the cost of the options, and the foregone interest income if bonds were liquidated to buy the options.

Question 9

Money Duration

Answer 9

Used to determine positions to take. Money duration is market value multiple by (modified duration/100).