Question

Amy is a fixed-income portfolio manager. One year ago, given her expectations of a stable yield curve over the coming 12 months and noting that the yield curve was upward sloping, She elected to position her portfolio solely in 20-year US Treasury bonds with a coupon rate of 4% and a price of $101.7593. After a year, she sells the bonds at a price of $109.0629.

a. Which yield curve strategy was most likely implemented by Amy last year?

Circle one. Sell Convexity / A barbell structure / Riding the yield curve

b. Now Amy is expecting the interest rates over the next 12 months to be highly volatile. She is seeking your advice on how to reposition the portfolio. Would you recommend her to sell or buy the call options on the bonds held in the portfolio, and why?

Answer 1

Solution A: Riding the yield curve

Reason: Riding the yield curve strategy simply means that as bond's time to maturity declines, it will decline in yield if the yield curve is upward sloping.Since One year ago, her expectations were of a stable yield curve over the coming 12 months and the yield curve was upward sloping.By selecting her portfolio solely in 20-year US Treasury bonds with a coupon rate of 4% and a price of $101.759 and a year later selling the bonds at a price of $109.0629 simply indicates that she anticipates of making profit from price increase as the time to maturity shortens. Here she is not just accumulating the coupon income for one year but also expecting to add to returns by selling the security at a lower yield at horizon. By targeting portion of yield curve( 20 year) that are relatively steep she is expecting to earn significant price appreciation resulting from bond's migration to maturity.

Solution B: Buy call option to buy convexity when high volatility expected

Reason: Since Amy is expecting the interest rates over the next 12 months to be highly volatile, Means she will buy convexity to gain in volatile environment. Convexity can be purchased when you buy call option.Adding options (i.e instrument) in a portfolio that will add more curvature to the price yield function of his portfolio and that will add convexity.In a highly volatile environment, price of bond with higher convexity increases more if interest rate decline and decreases less if the interest rate rise in comparison to a bond which is of same duration but has low convexity.