Case 032Rates and hedgingCore

Pitch a 10-year rates trade to a fixed income fund: the 10-year government bond yields 7.10%, the 2s10s curve is 40 basis points, and you expect the central bank to ease. Size a DV01-neutral steepener and set the stop.

Bank of AmericaLondon · 2025

The situation

You cover Pratyush Fixed Income Fund, a government and high grade bond fund. The 10-year government bond yields 7.10% and the 2-year 6.70%, so the 2s10s slope is 40 basis points. Inflation prints have come in soft two months running, and your view is that the central bank starts cutting within two quarters.

The fund's manager says she already has plenty of duration and does not want to add more. She asks for a trade on the 10-year that expresses your view without betting on the overall level of yields. Use Rs 500 crore as the size of the short-end leg.

Your task

Name the trade, size the legs so it is DV01-neutral, show the profit in your scenario, and set a stop-loss and a reason to exit.

Quick check

If every yield on the curve falls by 30 basis points, what does a DV01-neutral steepener make?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Pitch a bull steepener: buy Rs 500 crore of 2-year bonds and sell about Rs 130 crore of 10-year, so each leg moves Rs 9.1 lakh per basis point. Easing should pull the 2-year down more than the 10-year. If the 2-year falls 50 basis points and the 10-year 20, the slope widens from 40 to 70 and the trade makes about Rs 2.7 crore. Stop out if the slope flattens to 25, a loss of about Rs 1.4 crore.

Step 1Why a curve trade rather than simply buying the 10-year?

A shopkeeper who expects mangoes to get cheaper relative to apples does not care whether fruit prices in general rise or fall; she wants a bet on the gap. A curve trade expresses a view on the shape of the curve and strips out the level, which is what the manager asked for. When a central bank eases, short yields track the policy rate closely while long yields also carry inflation and supply expectations, so the short end usually falls further. That is a bull steepeningYields fall across the curve, but short-dated yields fall more than long-dated ones, so the gap between them widens..

A bull steepening: short yields fall more than long ones6.0%6.4%6.8%7.2%2y5y10y6.70%6.20%7.10%6.90%-50 bp-20 bpnow: 2s10s = 40 bpafter: 2s10s = 70 bp
In the easing scenario the 2-year yield falls 50 basis points to 6.20% and the 10-year falls 20 to 6.90%, so the 2s10s slope widens from 40 to 70 basis points.
Step 2How do you size the two legs?

Equal notionals would not be neutral, because a 10-year bond moves far more per basis point than a 2-year. The 2-year's modified duration is about 1.82 and the 10-year's about 6.99. Rs 500 crore of 2-year moves Rs 9.08 lakh per basis point, so the 10-year leg is Rs 500 crore times 1.82 over 6.99, about Rs 130 crore. In practice the fund would sell 10-year bond futures or pay fixed on a swap for that leg, and each carries its own basis to the cash bond.

The relationship
N10=N2×D2D10=500×1.826.99≈130N_{10} = N_{2} \times \frac{D_{2}}{D_{10}} = 500 \times \frac{1.82}{6.99} \approx 130
Nnotional of each leg, Rs crore
Dmodified duration, the per cent price change for a 1 percentage point move in yield
What it says in wordsScale the long-end notional down until one basis point moves both legs by the same number of rupees.
Step 3What does the trade make, and where do you stop?

In the easing scenario the long 2-year gains 50 times Rs 9.08 lakh, about Rs 4.54 crore, and the short 10-year loses 20 times the same, about Rs 1.82 crore. The net is 30 basis points of steepening times Rs 9.08 lakh, about Rs 2.72 crore, and a parallel move of any size makes roughly nothing. Set the stop at a slope of 25 basis points, a loss of about Rs 1.36 crore, against a target of 70: roughly two to one.

What the trade earns depends on the slope, not the level, Rs crore00.00All yields -30 bp0.00All yields +30 bp+2.72Bull steepen +30 bp-1.36Flatten to stop, -15 bpLegs sized so each moves Rs 9.08 lakh per basis point
The DV01-neutral steepener makes about zero on a parallel 30 basis point move either way, about Rs 2.72 crore on the bull steepening, and loses about Rs 1.36 crore if the slope flattens 15 basis points to the stop.

Close the pitch with what would prove you wrong and what it costs to wait. If inflation re-accelerates and the central bank holds, the short end sells off first and the curve flattens, which is exactly the stop. Add a time stop too: a steepener often gives up a little carry each month while you wait, so if the cuts are not priced within about three months, exit and rethink rather than sit on a view the market is not sharing.

Where candidates lose it

The usual loss is sizing the legs on equal notionals. Rs 500 crore against Rs 500 crore is a large short-duration position in disguise, and a parallel rally would lose money on a trade meant to be neutral to the level.

The second is pitching the view without an exit. A trade idea without a stop and a reason to leave sounds like a guess; interviewers want the level at which you would admit being wrong.

What the interviewer asks next

  • How would you express the same view using swaps instead of bonds?
  • What is the carry and roll-down on this position, roughly, and does it help or hurt?
  • The central bank cuts but signals it is one and done. What happens to your trade?
  • When would you prefer a bear flattener?

Asked at Bank of America, Sales and Trading, London, 2025 (Wall Street Oasis): had to pitch a 10y trade idea. no crazy technicals, just wanted to see if i actually follow the macro market

Company names and figures are illustrative.