First, when a yield curve flattens, are we suggesting that the short-end rate doesn’t change and long-end rate decreases? Kaplan material says if curve decreases, one should buy the body and short the wings. CFAI’s official answer seems to suggest when curve flattens, one should long the wing and short the body (meaning Long end rate decreases the most).
Second, what does short “pay fixed swap” mean? Is it equivant to “receive fixed”? If that’s the case, does “receive fixed” mean we long the body? which contradicts the short body theory of CFAI’s official answer.
the curve flattens so you expect the long term yield to go down hence it is better to have a long position on long term bonds to benefit from this decrease in the yield.
my understanding is like yours: Shorting a payer swap is equivalent to longing a receiver Swap
this being said, i am also confused with the proposed solution.
my understanding is that a fixed reciever is equivalent to holding a bond (so you recieve fixed coupons). if the above definition is correct then the final position is equivalent to a long of Long term, mid term and short term bonds which does not seem like a butterfly
I agree I think this one is worded really poorly. But the curriculum does state several times that butterfly with long the wings/short belly benefits from flattening environment and C is the only answer that fits. I was confused by the short pay fix as well. Rightly or wrongly, since the question didn’t state HOW he thinks the curve will flatten, I went with the simplest scenario which is the twist. In that case, the middle is “pinned” and yields there are unchanged so pretty much irrelevant what you do there. I also thought maybe they’ve reused this question and switched out the securities in the exhibit but didn’t change the answer choices?
