19. A trader values off?the?run bonds using interpolated yield to maturity data from on?the?run bonds. How can one profit from this trader's valuation methodology when the yield curve is upward sloping?

A. Buy off?the?run bonds with above market coupons from the trader and sell to the trader off?the?run bonds with below market coupons.

B. Buy off?the?run bonds with below market coupons from the trader and sell to the trader off?the?run bonds with above market coupons.

C. Buy from the trader off?the?run bonds with above and below market coupons.

D. Sell to the trader off?the?run bonds with above and below market coupons.

Correct answer is Afficeffice" />

The duration of the off?the?run bonds with above market coupons is lower than the duration of on?the?run bonds with the same maturity. In an upward sloping yield curve, the yield the trader is using to value these bonds is too high, resulting in a price which is too low. One can profit from this pricing error by buying these bonds from the trader. The duration of the off?the?run bonds with below market coupons is higher than the duration of on?the?run bonds with the same maturity. In an upward sloping yield curve, the yield the trader is using to value these bonds is too low, resulting in a price which is too high. One can profit from this pricing error by selling these bonds to the trader

A is correct. As explained above, off?the?run bonds with below market coupons are too expensive and off?the?run bonds with above market coupons are too cheap. Selling too expensive and buying too cheap will result in a profit.

B is incorrect. As explained above, off?the?run bonds with below market coupons are too expensive and off?the?run bonds with above market coupons are too cheap. Buying too expensive and selling too cheap will result in a loss.

C is incorrect. As explained above, off?the?run bonds with below market coupons are too expensive. Buying too expensive result in a loss.

D is incorrect. As explained above, off?the?run bonds with above market coupons are too cheap. Selling too cheap will result in a loss.

Reference: John Hull, Options, Futures, and Other Derivatives, 5th ed (ffice:smarttags" />New York: Prentice Hall, 2002), Chapter 5.