FRMStrawberry
Member
Hi David,
Please see the question as below and help me understand the solution I can n't understand.
26.2. A fixed income arbitrate strategy manager takes two positions: she takes a short position in an interest rate swap (she is the floating-rate payer) with a notional of $10.0 million and a short position in Treasury bond with current value (price) of $7.0 million. The modified duration of each position is 4.0 years, to ensure an arbitrage, the net dollar (value) duration of the combined position is zero. The Treasury spot rate yield curve is flat at 2.0% and the swap rate curve is flat at 3.0%. If we ignore convexity and rely only on a linear approximation, and we further assume that swap spreads cannot become negative, what is the upside on this trade? (variation on example 30.5 in FRM Handbook, 6th Ed, page 764)
a) Zero
b) $280,000
c) $700,000
d) Unlimited
solution:
For example, market rates can increase by 2% such that the Treasury curve increases to 4.0% and the swap rate curve increases to 5.0%, but this will produce approximately no net gain: the gain in the Treasury bond will be approximately offset by the loss in the interest rate swap. The net gain is therefore limited to swap compression.
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The highlighted part is not that straightforward to me. Could you please explain it to me a little bit? Thanks.
Please see the question as below and help me understand the solution I can n't understand.
26.2. A fixed income arbitrate strategy manager takes two positions: she takes a short position in an interest rate swap (she is the floating-rate payer) with a notional of $10.0 million and a short position in Treasury bond with current value (price) of $7.0 million. The modified duration of each position is 4.0 years, to ensure an arbitrage, the net dollar (value) duration of the combined position is zero. The Treasury spot rate yield curve is flat at 2.0% and the swap rate curve is flat at 3.0%. If we ignore convexity and rely only on a linear approximation, and we further assume that swap spreads cannot become negative, what is the upside on this trade? (variation on example 30.5 in FRM Handbook, 6th Ed, page 764)
a) Zero
b) $280,000
c) $700,000
d) Unlimited
solution:
For example, market rates can increase by 2% such that the Treasury curve increases to 4.0% and the swap rate curve increases to 5.0%, but this will produce approximately no net gain: the gain in the Treasury bond will be approximately offset by the loss in the interest rate swap. The net gain is therefore limited to swap compression.
****
The highlighted part is not that straightforward to me. Could you please explain it to me a little bit? Thanks.
