Melissa Clarke, a recent graduate of Harvard Business School, is a mortgage-backed securities (MBS) portfolio manager at Star Flag Fund. The fund primarily invests in Agency MBS, that is, those issued by US Agencies such as Fannie Mae and Freddie Mac. The fund also uses various interest rate products such as US Treasuries, interest rate futures and interest rate swaps (IRS) to manage the fund's duration, cash flow and market risk. A recent economic crisis has sharply reduced US interest rates, including fixed rates offered on conventional mortgages. The sudden drop in interest rates has sparked a re-financing boom, as US homeowners scrabble to refinance existing mortgages at lower interest rates. Clarke is worried about this development and notices that due to accelerated mortgage prepayments, the portfolio's average duration has contracted from 5.7 years to 4.1 years. Having a lower duration in an environment of falling interest rates will clearly hurt Star Flag Fund's performance. Clarke wants to adjust the portfolio's duration back to its target duration to offset the impact of increased MBS prepayments

Fund information and market data are contained in the table below. USD IRS convention is to quote the fixed rate vs 6-month Libor.

Also, assume all US IRS transactions are centrally cleared.

Fund size	$600 million
Fund target duration	5.5 years
Average duration of Agency MBS	3.7 years
Duration of 5y US Treasury	4.6 years
6m USD Libor	1.875%
5y IRS bid-offer quote	2.015% to 2.025%
Zy IRS bid -offer quote	2.125% to 2.140%

8. If after having executed the appropriate swap to achieve the Fund's target duration, Sy swaps rates rise. Marking to market the swap is likely to show

1. A change in valuation resulting in a gain
2. A change in valuation resulting in a loss
3. An unchanged valuation