Suppose you are managing a portfolio of fixed income assets and you have formed the following prediction of the yield curve 6 months from now: short-term yields will increase by 1%, long-term yields will decrease by 1% and there be little change in mid-term yields. Which of the following trading strategies would provide you the best outcome if your prediction is correct? Short the short-term bonds. Long the short-term bonds. Short the long-term bonds and mid-term bonds. Short the long-term bonds and long the short-term bonds.
Question
Suppose you are managing a portfolio of fixed income assets and you have formed the following prediction of the yield curve 6 months from now: short-term yields will increase by 1%, long-term yields will decrease by 1% and there be little change in mid-term yields. Which of the following trading strategies would provide you the best outcome if your prediction is correct? Short the short-term bonds. Long the short-term bonds. Short the long-term bonds and mid-term bonds. Short the long-term bonds and long the short-term bonds.
Solution
Given your prediction, the best trading strategy would be to short the short-term bonds and long the long-term bonds. Here's why:
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Short-term yields are predicted to increase. When yields increase, bond prices decrease. Therefore, if you short (sell) the short-term bonds now, you can buy them back later at a lower price when yields have increased. This would result in a profit.
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Long-term yields are predicted to decrease. When yields decrease, bond prices increase. Therefore, if you long (buy) the long-term bonds now, you can sell them later at a higher price when yields have decreased. This would also result in a profit.
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Mid-term yields are predicted to remain relatively unchanged, so there's no clear advantage to shorting or longing these bonds.
So, the best strategy would be to short the short-term bonds and long the long-term bonds.
Similar Questions
Suppose you are managing a portfolio of liability and the predicted the bond yield will slightly increase by 0.1% per year for the coming 10 years. Which trading strategy below would provide you the best outcome?Issue short-term bonds and buy long-term futures.Buy-back long-term bonds or long-term futures.Buy-back short-term bonds and sell long-term futures.Dispose long-term bonds and buy short-term bonds
Which of the following items will likely not affect the shape of the yield curve?Group of answer choicesMore efficient transaction systems of financial assetsThe market experiencing increasing concerns about the financial health of the economyAn sudden increase in demand for long-term bondsThe market forming a more optimistic outlook of the future of the economy
Which of the following statements is correct? Group of answer choices A steepening of the yield curve could reflect a belief that the central bank will in the future conduct a more restrictive monetary policy than previously thought. The yield curve reflects the relationship between existing short, medium and longer term interest rates, independent of expectations about future interest rates. The yield curve reflects the effect of arbitrage in financial markets not what the current interest rate is in the overnight market. A steepening of the yield curve could reflect long-term government bonds suddenly being seen as a more attractive investment.
The existence of an upward-sloping yield curve suggests that:Select one:a.bonds should be selling at a discount to par value.b.bonds will not return as much as common stocks.c.interest rates will be increasing in the future.d.real interest rates will be increasing soon.
If a yield curve looks like the one shown in the figure below, what is the market predictingabout the movement of future short-term interest rates? What might the yield curveindicate about the market’s predictions for the inflation rate in the future?
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