It is November 30, 2010 and you hold a $1mm (market value) long position in the 1-yr zero-coupon bond. Using modified durations, determine how much of the 5-yr zero- coupon bond you need to short so that your portfolio remains approximately unchanged if the 1-yr and 5-yr zero rates move in parallel. This is known as a steepener trade - you profit if the yield curve becomes steeper. What is the market value of your portfolio?

Question B: Steepener Trade Suppose you have the zero-coupon yields (reported in %) below. Assume that the yields are annually compounded. date yield 1yr yield 2yr yield 3yr yield 4yr yield 5yr 20101130 0.317 0.444 0.716 1.083 1.479 20101231 0.352 0.575 1.008 1.545 2.04 1. It is November 30, 2010 and you hold a $1mm (market value) long position in the 1-yr zero-coupon bond. Using modified durations, determine how much of the 5-yr zero- coupon bond you need to short so that your portfolio remains approximately unchanged if the 1-yr and 5-yr zero rates move in parallel. This is known as a steepener trade - you profit if the yield curve becomes steeper. What is the market value of your portfolio? 2. What actually happens during the following month? Calculate the value of your portfolio. A 1-yr bond is now an 11-month bond and a 5-yr bond becomes a 4-year 11-month bond. Assume for pricing purposes that the 5-yr rate applies to the 4-yr 11-month bond and the 1-yr rate applies to an 11-month bond when calculating bond prices. Why did your portfolio value change from before? 3. What would the change in your portfolio value have been if the 1-yr rate had stayed the same and the 5-yr rate had gone down by 0.5 percentage points