Long/Short Butterfly Trade


Maturity: 1, 5, 10, 30

Forecast change in Yield: +0.03%, +0.5%, +0.6%, 0.00%.

For a long/short butterfly trade, the answer suggests shorting both the 5 and 10 year bond.

Why is there any benefit to shorting the 5 year when the 10 year will be more profitable? Why not just short the 10 year?

Thanks :slight_smile:

Where, exactly, is this?

Hi S2000 :slight_smile:

I’ve reworded my question above as i dont think it was clear.

Page 46 of schweser 2018 practice exams vol 1. Exam 1, afternoon, question 30.

More of a qualitative answer from my own experience but a single maturity rate won’t increase and leave the rest of the yield curve unchanged, that would lead to a spiked yield curve which I’ve never seen before. If the 10-year rate is expected to increase, nearby rates will move too (but not to the same extent) in order to form a normally shaped curve. The 5-year rate in this example will increase by 50bps and 10-year by 60bps so shorting both 5 and 10 makes sense both from an expected yield change perspective as well as an expected yield curve shape (although flat/inverted curves are possible, but again, multiple rates will move, not just 1 maturity).

Moonborne, wouldnt shorting just the 10 year rate be a more effective short though? Not arguing that the rates around it wont move too, but the 10 year rate is forecast to be the most profitable.

If i forecast stock A will move down $20 and stock B will move down $10, why bother with stock B? Lets just short as much of stock A as possible (ignoring diversification benefits etc)

I had the exact same question going through my mind since I answered 10Y only as well.

I read the question again and it said ‘you can select one or two bonds’. If you can only short 1, then ofc the 10Y is the better choice. But if you can short more than 1, then you should short the 5Y as well. Maybe look at it this way: if you can earn $10 by shorting 10Y and $5 by shorting 5Y, then why not both so you can gain $15.

@keroppi, why not just short more of the 10 year though?

i thought about that too…hence I chose 10Y only.

we just have to assume you can only short 1 unit of each?

I dont see this assumption anywhere…

The question is not really clear because it’s not precise how many bond we must short.

To a certain extent, we could say that we need to short the 1-year bond as well. Because the 1year rate increases +0.03%.

I am, by no means, an expert but my reasoning is that If only the 10y is shorted your profit is offset by your loss on the 5yr. Max profit earned when profiting on both shorts.

Apparently shorting the 5 and 10 year while longing the 1 and 30 year is actually a condor trade?

I think schweser has just written a bad question (again)

This trade can either be a Condor or an Enhanced Barbell…

Since the yield for 1, 5 and 5 years is upward sloping, while that of 30 years remained constant, then it is logical to short both the 5 and 10 year bond and long both 1 and 30 year bond.

The above simply mean the level of curvature is high.

When curvature is high, you short the medium term bonds and long both the short and long bonds (thus an Enhanced Barbell or Condor works best).