Question 3 (10 Marks)

You are the manager of a large portfolio of liabilities comprising 90-day commercial paper, along with 3-, 6- and 10-year bonds. New advice suggests that the yield curve is likely to make a parallel shift downwards, a move that is apparently not currently predicted by the market.

1. Outline how you would alter your portfolio to take advantage of the predicted move in the yield curve. Broadly, what will be the impact of this portfolio restructuring on the portfolio duration. (2 Marks)

2. Outline how you would use futures to take advantage of the predicted move in the yield curve. Assume that both 3- and 10-year bond futures are available to you. (2 Marks)

3. Outline how you would use a swap to take advantage of the predicted move in the yield curve. Assume that the following swap instruments are available. The applicable interest rate for the floating side of the swap is 5.02%. Today is March 15, 2002. (2 Marks)

Instrument	Coupon	Maturity	Swap rates
IRSDB04	5.70%	15-09-04	5.66/5.70
IRSDB06	5.95%	15-09-06	6.02/6.06
IRSDB11	6.25%	15-09-11	6.46/6.50

4. What could cause swap spreads to widen? (2 Marks)

Describe an economic situation that could cause the yield curve to have a downward parallel shift as described above