Question
Suppose R1 = 2-year zero-coupon riskless rate, R2 = 10-year zero-coupon riskless rate, and RF is the implied forward rate from 2 to 10 years.
Suppose R1 = 2-year zero-coupon riskless rate, R2 = 10-year zero-coupon riskless rate, and RF is the implied forward rate from 2 to 10 years. At present, R2 > R1. (A) You expect the term premium (defined as TP = (R2 R1) to shrink in three months because of an expected increase in R1. Should you buy or sell the implied forward rate instrument to profit from the expected decline in TP? Why? (B) Suppose you expect the term premium turn negative in three months (i.e., the yield curve would invert) because of an expected sharp increase in R1. Discuss an active investment strategy that involves trading R1 and R2 to profit from the expected yield curve inversion?
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