need explanation for question 2 and 3 in the above example
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Explanation for Question 2 :
Advantages of holding 2Y bond – less duration to carry the Greek uncertainty risk with higher cash flow as coupon of 2Y is greater than 10y bond (4.75 vs 3) & higher spread over german bonds (2y spread 5.87 & 10y spread 5.48).
Disadvantages of holding 2y bond – If spreads tighten as is the view shared in the write up, the yield pickup will be lower as duration is less. Moreover, absolute yield pickup is lower in holding 2y vs 10y bond.
Advantages of holding 10y bond – 10- year offers a higher yield and greater
opportunity to benefit from the view that spreads will tighten. Roll down strategy will also be good in 10y bond vs 2y bond.
Disadvantages of holding 10y bond – if the view of decline yield spreads is incorrect, longer 10y duration can result in substantial loss. 10y has fairly high duration and any rise in risk of periphery countries in a risk off scenario can result in massive loss vs holding 2y bond.
Explanation to Question 3 :
Now, in the write up 2 views are expressed :
To express & benefit from both the views and not taking substantial duration risk, Costos is likely willing to do a 10y asset swap.
Costos is willing to buy the 10y Greece bond (as his view of Greece bond spreads to narrow) but do not want to caught on wrong side of European bond yields or yield curve rising so, he wants to fix the cash flow of bond (coupon) with the fix leg of the swap and receive the floating leg i.e. Libor + 220bps which will benefit him if there is general rise in yield curve or european bond yields in general rise.
Moreover, holding the 10y Greece bond outright also gives Costos substantial price appreciation (bond trading at 78.86% of par) if his view of Greece bond spreads tightening comes out correct.
Note : Please refer to the cashflow diagram attached.