The spot curve is currently upward-sloping and you think the Fed will be raising short- term interest rates soon. You want to take advantage of short-term yields rising relatively more than long-term yields, but you do not want to be exposed to changes in the general level of interest rates.

(a) What trading strategy should you put on to profit from this view?
(b) Your choice of assets are a two-year zero with a YTM of 1.5 percent and a ten-year zero with a YTM of 2.5 percent. With these two assets, describe the positions (long or short) you would take in each of them to implement your trading strategy
(c) Calculate the prices of each asset. Use annual discounting and assume the face value of each zero is $100
(d) Now calculate the dollar duration of each asset
(e) What is the optimal hedge ratio? Round the ratio to the nearest integer and interpret it
(f) Assume that you already have a ten-unit position in the ten-year zero (so either N10 = −10 or N10 = 10). Calculate the cost/value of you portfolio. (This can be negative if you put on a large short position)
(g) Now after putting on this trade, suppose the YTM of the two-year zero increases from 1.5 to 2.5 percent (assume the change was "overnight"). What is your portfolio cost/value now? If you decide to close out your position after the yield change, what is your dollar profit?

Answer rating: 100% (QA)

a To profit from the expectation of shortterm yields rising more than longterm yields while avoiding ... View the full answer