Yield Curve Strategies for CFA Level III

What this chapter covers

Yield Curve Strategies: topics in the order to study them

1. 1Yield Curve Dynamics and Duration MeasuresEverything else depends on describing curve moves as level, slope and curvature and measuring exposure with duration and key rate duration.
2. 2Static Yield Curve Strategies: Buy-and-Hold and Roll-DownThese are the simplest return calculations, with no change in the curve, and they build the return decomposition you will reuse.
3. 3Active Strategies: Bullets, Barbells and ButterfliesOnce you can measure exposure, you can see how different maturity structures respond to level, slope and curvature changes.
4. 4Yield Curve Scenario Analysis and Return DecompositionThis combines carry, roll-down and yield-change effects across several scenarios, so it needs the earlier topics first.
5. 5Term Structure Models and Yield Curve ViewsModels explain where views on the curve come from, and they make more sense once you have seen how the curve is used in strategies.
6. 6Derivatives-Based Yield Curve PositioningFutures and swaps are the implementation layer, so you study them last, when you know which exposure you want to create.

How to prepare Yield Curve Strategies

1. Define level, slope and curvature in your own words, and note which duration measure fits each type of curve move.
2. Practise return decomposition on paper: coupon income, roll-down, price change from the yield move, and any other items. Write every step so a slip still shows your method.
3. Compare bullet, barbell and butterfly structures for the same duration. Note how each behaves under a parallel shift, a steepening, a flattening and a change in curvature, and where convexity differs.
4. Run a scenario table with at least three curve paths and compute the expected return for each position. Then state which position you would choose and why.
5. Read the model topic for the idea each model captures and what view it supports. Do not memorise formulas you cannot apply.
6. For derivatives, practise turning a target duration or key rate exposure into a position size, then check the sign and direction of the hedge.
7. Finish with timed item sets and essays. For recommendations, name the position, give the reason from the client's objectives and constraints, and stop.

Common mistakes in Yield Curve Strategies

• Treating every curve move as a parallel shift.

  Fix: Identify the type of move first (level, slope, curvature), then pick the duration measure and structure that match it.

• Assuming roll-down return always exists.

  Fix: Check the curve shape and the bond's maturity. Roll-down depends on the yield changing as the bond ages, and it can be zero or negative.

• Leaving out parts of return decomposition.

  Fix: List every return component before calculating and tick each off. Show each step so partial credit is possible.

• Comparing bullets and barbells without matching duration.

  Fix: Set equal duration, then discuss convexity, yield and slope or curvature exposure.

• Getting the direction of a derivative position wrong.

  Fix: Before answering, state whether you need more or less duration, then choose the position that does that and check the sign.

• Writing a recommendation that ignores the client.

  Fix: Open the justification with the client factor that drives the choice, such as risk tolerance or liability profile, then link it to the position.

Last-day revision: Yield Curve Strategies

• ✓A curve move is described by level, slope and curvature changes.
• ✓Effective duration measures exposure to a parallel shift; key rate duration measures exposure at specific maturities.
• ✓Money duration is the duration times the position value, so use it to size positions and hedges.
• ✓Buy-and-hold return comes from coupons, reinvestment and the price at the end of the horizon.
• ✓Roll-down return exists when the curve is upward sloping and the bond is priced at a lower yield as maturity shortens, assuming an unchanged curve.
• ✓Expected return = carry + roll-down + price effect of the expected yield change, adjusted for any other items given.
• ✓A barbell has more convexity than a bullet of the same duration, but yields differ and the benefit depends on the curve change.
• ✓For equal duration, a bullet tends to outperform a barbell when the curve flattens (long-end yields fall by less than short-end yields, or short-end yields rise), and a barbell tends to outperform a bullet when the curve steepens. The result depends on the actual key rate changes, so check them rather than relying on the label.
• ✓Match duration first, then compare structures on curvature and slope exposure.
• ✓Run several scenarios and compare expected returns; do not rely on one forecast.
• ✓Futures and swaps adjust duration or key rate exposure without selling bonds.
• ✓In essays, tie the recommendation to the client's objectives and constraints in the fewest words that answer the command word.

Yield Curve Strategies in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

• NISM CertificationsInvesting in Fixed Income Securities (NISM XXI-A)
• CFA Level IInterest Rate Risk and Return
• CFA Level IIThe Term Structure and Interest Rate Dynamics
• FRM Part IIThe Investment Function in Financial Services Management