Derivative-based enhanced indexing strategy

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sticky

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This is p.146, Schweser 3, OR p.135, CFAI 4.
Schweser says:
“The manager holds cash position and a long position in an equity futures contract. The manager can then attempt to generate an excess return by altering the duration of the cash position. If the yield curve is upward sloping, the manager invests longer-term, if she thinks the higher yield is worth it. If the yield curve is flat, the manager invests in short-duration, fixed incomes securities, because there would be no reward for investing on the long end.”
CFAI mentions something similar.
Can sb explain on this?
1. Especially on the duration part.
2. Now what kind of exposures will I have if I believe “yield curve is upward sloping”?
Thanks.
- sticky
 
coming to the exposures… I think that we would buy long term bonds if the yield curve is upward sloping…
 
Upward sloping yield curve implies that longer term bonds are yielding higher return than shorter term. So you invest for the long term and lock in higher rates. This means you have increased the duration of your portfolio (cash - -> long term bonds). Actually even short term bonds will result in increase in duration but obviously not by as much.
What Schweser is trying to say in fancy words is that taking on an interest risk exposure (through increased duration) can result in higher return.
 
another explanation on this could be:
upward sloping normally occurs when monetary policy is in expansion. short rate is trending down. in this environment, it would be wise to lock in a long rate to avoid negative impact of reinvestment risk. (Or, we could say, increase duration to take advantage of declining interest rate.)
on the other hand, when fed tightens its monetary policy, short rate is trending up and yield curve flattens, it would be wise to invest in short-duration bond. in this case, the reinvestment risk works in favor of short bonds. (Or, we could say, lower duration to reduce interest risk.)
* following the same logic, barbell portfolio performs better than bullet portfolio when yield curve flattens.
 
so what are the answers to 1 and 2?
- sticky
 
actually higher long term yield only means u r paying a depreciated or cheaper price for the long term bonds… what we recieve is only the coupons which can be reinvested at a higher rate..
 
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