Bear flattener

Broad’s first meeting of the day is with Gabriella Bhavathi. Bhavathi is an active manager with a view that the yield curve is expected to undergo a bear flattening. She has positioned her portfolio to profit from this view using only zero-coupon bonds with maturities of two and ten years. Broad points out that the view of the chief economist at Equinox is that the yield curve will flatten but not undergo a bear flattening. Broad suggests that Bhavathi bring her portfolio into line with the view of the chief economist unless she has good reason not to do so.

If Bhavathi brings her portfolio into line with the view of Equinox’s chief economist, Bhavathi will most likely adjust her portfolio position by:

A) reducing an existing short position in the 2-year zero-coupon bond.

B) increasing an existing long position in the 2-year zero-coupon bond.

C) increasing an existing short position in the 10-year zero-coupon bond.

I would have went for C. My explanation: you do not position for a bear flattening curve, but simply flattening, so you want to go into longer durations…
Correct answer is A. Could someone please explain why? Thanks!

First, figure out what the original position is:

  • Is she likely long or short the 2-year? Why?
  • Is she likely long or short the 10-year? Why?

The yield curve will flatten meaning rates will reduce and price will increase. This will affect short positions so its better to reduce. The question says “not a bear flattening”

Not necessarily.

In a bull flattening they will, but in a bear flattening they won’t; you can also have the long end fall and the short end rise.

I concur it should be A. Her initial position was to profit from a bear flattening. In that scenario, rates are rising but ST rates are rising more than LT rates. To profit from this without messing with your portfolio duration too much, you would need to short ST bond and buy LT bonds.

The chief economist’s position is that only the long end of the curve will experience a fall in rates (ie. flatten but not bear flatten). To profit from this, one would buy LT bonds. Broad already has this position. She just needs to reduce her existing short position in the ST bonds which she took when she thought there would be a bear flattening.

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Thanks! You explained it so well. I see. The key is to keep “duration neutral” here. That is why I was always confused about all these bull/bear steepening/flattening things.