longer maturity paper vs short-term paper, which one is more attractive in the context of rising / falling interest rates?

CFA Level III
#1

CFAI is confusing me on this.

Quote page 86 in reading 18 CME

“normally, longer-maturity paper will pay a higher interest rate than shorter-maturity paper, even if overnight rates are expected to remain the same, because risk of loss is greater for the longer-term paper if this expectation is not fulfilled. If further rises in rates are expected over time, then 6-month and 12-month paper should offer even higher rates than short-term paper”

then, in the solution give in example 31 on the next page. They are kind of saying the opposite thing. quote "by contrast, the first strategy (buying short-term paper) counts on interest rates rising, not decline. The first strategy would produce higher returns only if interest rates rose" which to me it suggests buying short-term paper is more attractive than longer-term paper if expecting rate rises

Sheweser also agrees that cash manager should buy short-term rather than long-term if they expect rates to rise

Any one can share their thoughts?

#2

first statement is based on expectations theory. If you are holding a longer term bond - you would need to be adequately compensated for holding it - which means you earn a higher yield. So based purely on expectation - if current short terms rates are rising - the 6 month out rate and the 1 year out rate should be MUCH higher - to fulfil the expectations.

In strategy 1 - they are rolling over 1 month paper - and rates rise - the short term strategy would work of rolling over 1 month would be profitable. But here rates are dropping…

#3

Thanks CPK! Seems I forgot all my L2 stuffs!

#4

conceptually the easiest way to think of this problem is to consider a swap where the term is 6 months and the floating resets are monthly .

as an investor ,which side of the swap would you like to be when rates are rising ? You would like to receive floating while paying fixed. Which is strategy 1.

When rates are falling? you’d like to receive the fixed , pay the floating , which is strategy 2.

#5

Thanks janakisri!