Reading 13 Question 3- Swaps and durations


The answer to this question is B. I am not sure how to even approach this question. Can someone help please? I understand that Bear flattening = rising ST yields

Model answer: In the case of B, with twice the mod dur of the Barbel, will more than offset the existing long position–> (what long position are we talking about?)

This portfolio would then produce a net short 2 year and long 9 year bond position in the overall portfolio and gain under bear flattening. → (Why net short 2 year?)

When they say 9-year receive fixed AUD swap- does this mean we recieve 9 year yield curve rate of the AUD yield curve for 9 years?

Bear Flat happens when yield rise in short term. = Reduce duration to benefit.

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It did take me a few times to read it as its not the best worded question. I am not 100% sure what the person position is but it doesn’t matter too much.

Logically if you think yields are rising regardless of the options given you want to reduce the duration you have. One of the ways to do this via swaps is to pay Fixed (the leg with the duration) and receive floating. By doing this you are reducing the duration and thus the sensitivity to the rise in interest rates in the Bear Flattening. The other two answer would have you receive duration and increase your sensitivity to the interest rates rising.

Hope that helps!

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Thank you… this helps, so we don’t need to consider the modified duration comment in the answer, e.g. ‘twice the modified duration as the 2 year ov bond in the barbell portfolio’ for example? i dont get how twice the modified duration can be achieved here… or what it means

I think it is more a red herring to get you to focus on it but to play devils advocate you would if the question was different.

Hypothetically if all the answers were paying fixed then it could make a difference as you would then compare the difference durations sensitivities. i.e. If A instead was a 2 year pay Fixed swap with same duration as Bullet (4.2 years).

Then technically this would be better at reducing the overall duration than B) swap that has 2 x the MD as the 2 year (1.922 x 2 = 3.984).

Also note that all you are doing in the swap is swapping different duration amounts (swapping floating for fixed etc), I think the question might be confusing you by saying double that of a 2 year bond in B, really they should just say the duration of the swap is 4. It has nothing to do with the 2 year bond, only the duration number.