Hirji then considers a strategy to sell some long-term bonds from the French institutional client’s portfolio and purchase short maturity at-the-money options on long-term bond futures. The portfolio’s duration would remain unchanged. Prégent asks:
“How would portfolio performance be affected by this strategy if the yield curve were to remain stable?”
Q. The answer to Prégent’s question is that the portfolio would most likely experience:
- a loss.
- no change.
- a gain.
A is correct. Short maturity at- or near-the-money options on long-term bond futures contain a great deal of convexity. Thus, options increase the convexity of the French client’s portfolio. Options are added in anticipation of a significant change in rates. If the yield curve remains stable, the portfolio will experience a loss from both the initial purchase price of the options and the foregone interest income on the liquidated bonds.
