So if I understand the question correctly, we have a inverted yield curve and Kolarov thinks that interest rates will rise in the near future. To protect the bond portfolio from interest rate increases, the most appropriate portfolio structure is a BARBELL?
Why a barbell? If interest rates rise across the yield curve? In a barbell, the long end will get destroyed when rates rise while the rise in rates have very little effect on the short end?
The answer talks also something about the yield curve flattening and I don’t see how that has anything to do with the question.
I am also confused by this and chose bullet as my answer. I read the question in the same context that you did: existing inverted yield curve with an anticipation of increasing rates (doesn’t say parallel or nonparallel). Can’t see how a barbell outperforms in this environment - and this sounds like a steepening yield curve to me.
Guys, there`s less than a month to the test, this concept should be in your soul by now! Said that:
The question only says that interest rates will increase. Nothing is said about changing in the slope of the yield curve or about changing in curvature, so we must consider a parallel change in the yield curve. After this, you only have to remember that:
GIVEN THE SAME DURATION FOR BARBEL, BULLET AND LADDER:
As letsgo says (or, at least, strongly implies), the key here is the duration: if all of the portfolios have the same duration, then you want the highest convexity you can get when you expect rates to change.
Thanks letsgo for the hot tip. But as you so eloquently pointed out, the question makes no mention of a change in slope or curvature. It also makes no mention of a parallel shift or even duration. It simply states that “ rates increase”.
If I told you tomorrow that the fed is going to raise rates would you assume a parallel shift across the curve?
Man, you`re overthinking this problem. We have plenty of examples from the EOC exercises (from lvl1, 2 and 3) that, when is said only that interest rates are expected to rise/fall, and nothing else is said, we should assume a parallel shift in the yield curve.
Just as a follow up to this and what throws me in particular - the solution itself states:
“For increases in rates, yield curves tend to flatten”
Does the solution itself not imply a change in steepness in this scenario? And the fact that the yield curve is inverted means that in order for the yield curve to flatten, long rates must increase more than short rates, meaning you don’t want exposure to the long end of the curve here? I understand the theoretical answer here RE duration and convexity, asking this question more out of concern for what I might be missing.
