Question

The current term structure is flat. You expect interest rates to rise sharply over the next years. Select the best strategy from the ones given below.

(a) Buy bonds with a long duration.

(b) Buy bonds with a lot of convexity.

(c) Short-sell bonds with a long duration.

Answer 1

When the interest rates rise the price of bond falls. This implies that the is its best to short sell the bonds now. Short sell implies that you dont own the bond but enter into a contract of selling it by borrowing the same. You promise to return it to the original owner after a certain period of time. You sell it at the current price. At the time of return of the bond, the prices fall because interest rates rise. So you buy the same bond at a lower price and return it to the original owner from whom you borrowed it. The price difference is your profits. So option C is correct

Option a and be expose you to greater interest rate risk. To take a long position, you buy them at current price and the coupon rate, but when the market rates rise, there are better bonds in the market which give higher interest rate. So the value of this bond falls. This leads to a capital loss for you. Higher the convesity, greater is such capital loss. Longer duration bonds are more sensitive to interest rate risk because it takes longer for them to recover the initial investment. Therefore options a and b are incorrect.