Question

Question 8

1. If an investor buys long-term government bonds using proceeds from the sale of short-term government bonds, what kind of bond strategy are they engaged in?
2. Is the duration of such a strategy generally positive or negative? Explain
3. Briefly explain how the “inter-market spread” strategy works. Provide a simple example
4. Why do banks and other financial institutions engage in duration matching?
5. Explain briefly why duration matched portfolios need to be actively managed

Answer 1

a) selling a bond before maturity helps to maximize ROI as if interest rates decline from the purchase of the bond, the value of the bond increases/ Thus selling the bond early ensures locking in the capital appreciation. The proceeds are sued to buy the long term bond to take advantage of the buy low and sell high strategy.

b) The duration is positive as the long term bond is more sensitive to price changes

c) The inter market strategy works by longing futures of one commodity and shorting that of another. This benefits the investor when the underlying price of the long position increases and that of the short position decreases because then the investor makes profit in the startegy.

d) Duration matching helps to match the duration of the loan and the asset to reduce or control interest rate risk.