Bond Valuation

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heavenkid

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Assume that the following hypothetical Treasury securities(settlement date: 30-oct-02) are trading actively.

coupon maturity price

Bond A 8.00% 15-sep-03 100.35
Bond B 9.75% 15-aug-20 100.00

assume that an investor believes that all yield curves are going to flatten. Under this scenario and using these bonds, which of the following trades is correct?

a. intramarket trade that buys bond A and short sells bond B
b. intermarket trade that short sells bond A and buys bond B
c. intramarket trade that short sells bond A and buys bond B
d. intermarket trade that buys bond A and short sells bond B

answer is C

my book said, if you expect the yield curve to flatten, then short-term interest rates increase have to increase relative to long term interest rates(but not necessarily in absolute terms) therefore, short term bonds will underperform and long term bonds will outperform-this strategy is consistent with your beliefs. This is an intramarket trade.


First, I do not know what is difference between intra and inte market with respect to this case

Second, if interrest rates go up for short term then bond price is down. Is the reason that we have to short the bond? because we expect that price goes down.
(For long term bond case is vice versa )

thanks



ju-young
 
What book are you using? I don't recall the intra- inter market distinction from the CFAI materials, except with respect to spreads. (see page 492 of volume 5). If I had to make an answer, however, I would agree that the MOST correct answer would be an INTRA market trade, because we know we are talking about two treasuries (so both sides of the trade are within the same bond market).

The second part of your reasoning (the price of the short bond will go down as the yield rises) is correct.
 
to plyon

I am using old text book 2004 version. yes it is kind of classic.


thanks
 
Well, I wouldn't recommend using those texts, unless you are using a current version of Stalla or Schweser notes. However, I understand the economics of the situation may be challenging, so do what you have to.

I would think 2007 Level I material are inexpensive on ebay, however.
 
Looking at this in passing, I would assume since the yield curve is flattening, the bonds would both begin to trade closer to par. That being said, I would sell A and buy B given their current prices. Is this assumption intuitively correct?
 
alphabound, your course of action is basically consistent with the correct answer, C.

heavenkid, I second plyon's suggestion of trying to obtain more current materials on one of the various auction sites if possible. Alternatively, I think CFAI offers financial assistance, but I don't know the details of this program.

I'd hate to see you work so hard and risk failure due to obsolete resources.



Edited 1 time(s). Last edit at Tuesday, July 31, 2007 at 09:40PM by hiredguns1.
 
You want to hedge against a parallel rates shift, that's why you short A and go long B. You also want to hedge against a spread widening/narrowing, that's why you trade intramarket.
 
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