Excess return with volatility

CFA Level III Fixed Income
#1

Bill Simmons is the head US interest rate portfolio manager for Cannon. Simmons
believes that 2-year rates will remain stable while all other rates in the yield curve will
rise by 50 bps. Simmons presents key rate duration data for the index and two portfolios
to the investment committee, as shown in Exhibit 1.
Exhibit 1
Tenor Index Portfolio 1 Portfolio 2
2-year 0.75 1.50 0.75
5-year 1.75 1.00 2.00
10-year 2.75 2.75 2.00
30-year 2.25 2.75 2.25
John Rucker, a member of Cannon’s investment committee, agrees with Simmons’s
view for interest rate levels but also believes that interest rate volatility will likely rise in
the coming year. Rucker wants to use derivatives to capitalize on the out-of-consensus
view and asks other members of the committee for ideas that could generate positive
excess returns for clients.

Given Rucker’s outlook, which action is least likely to generate excess portfolio
returns?
A. Short a payer swaption on a 10-year rate.
B. Long a call option on a 5-year futures contact.
C. Long a put option on a 10-year futures contract.

So, to me, Rucker’s outlook: increase in volatility, that is actually the opposite of a static curve.
If I think about the fact, in static, you want increased duration, then the opposite must be true here.
So, the worst for you would be B. long call, no?
However, if I think about convexity, which would be good in volatility, then the worst option is to decrease convexity. So, A.

Which rationing is correct, in this case? Many thanks!

#2

You would want higher convexity in your positions (e.g., long options) if you expect higher interest rate volatility. So, that rules A out.

1 Like
#3

My first instinct would be to eliminate A as I would not want to be short any kind of option/swaption if I am expecting volatility.

#4

One problem that Level III candidates face is that Exhibit 24 in reading 13 claims that long put options on bonds and bond futures, as well as long payer swaptions, decrease convexity. That’s incorrect, of course, and they’ll be removing all references to convexity in that Exhibit (instead of correcting the errors) in an erratum that will be coming out . . . well . . . sometime in the future, but in the interim candidates are left to believe the error.

1 Like
#5

Oh yes! I noticed :frowning: I failed my level III last year, so I am retaking it now… and, of course, I can still remember what I learnt about convexity and duration, including options. I thought I understood it wrong the entire time… put and call having the same effect?! Anyway… will learn it the “old way”.

2 Likes
#6

I understand the volatility part, but WHY would you want to long a call on a bond knowing prices are going down? 5 Yr rates are rising, so shouldn’t you lose if you long a call?