The manager is considering portfolio strategies based upon various interest rate scenarios over the next 12 months. She is considering three long-only government bond portfolio alternatives, as follows:
- Bullet: Invest solely in 4.5-year government bonds
- Barbell: Invest equally in 2-year and 9-year government bonds
- Equal weights: Invest equally in 2-year, 4.5-year, and 9-year bonds
Q. Assume the manager is able to extend her mandate by adding derivatives strategies to the three portfolio alternatives. The best way to position her portfolio to benefit from a bear flattening scenario is to combine a:
- 2-year receive-fixed Australian dollar (AUD) swap with the same modified duration as the bullet portfolio.
- 2-year pay-fixed AUD swap with twice the modified duration as the 2-year government bond in the barbell portfolio.
- 9-year receive-fixed AUD swap with twice the modified duration as the 9-year government bond position in the equally weighted portfolio.
Answer was B. But technically I wouldn’t choose any of these. If IR are rising and your swap has a modified duration twice as high as your government bond your going to lose money on your swap as well because IR rising with twice the sensitivity means discount factors are lower causing npv to be lower. I see this offsetting some of the gains from receving float in the higher IR environment. Isn’t my logic correct or am I overthinking this? I just chose the best possible answer which was B and that was correct.