2. (16 points) A portfolio manager has a mandate to maintain the portfolio duration at 6 - 7 years. Currently, in his portfolio, half of them is investing in Bond A and half in Bond B.

Bond A Years toMaturity5 Yield to Maturity 7% Modified Duration 4.2

Bond B Years toMaturity10 Yield to Maturity 7% Modified Duration 8.2

a. He has a view that interest rate will go down. How will he adjust the portfolio to capture this view? (That is, to swap x% of Bond A to Bond B or vice versa.) (8 points)

b. i) One year passed by, should the portfolio manager would like to maintain the portfolio duration and assuming the market interest rates have come down and stabilized, what should he do? Why? (4 points.)

ii) One year passed by, should the portfolio manager believe that the bond rally has come to an end and interest rates will go up instead. What do you think he will do? Explain. (4 points)