Explanation

The correct strategy is to buy Bond C and sell Bond B.

Scenario Analysis:

• Yield curve flattening due to decrease in long-term rates means long-term rates are falling while short-term rates remain relatively stable
• When long-term rates decrease, bond prices increase

Bond Characteristics:

• Bond A (Putable): Benefits from falling rates (price increases) but has embedded put option that caps upside potential
• Bond B (Callable): Has limited upside potential because issuer can call the bond when rates fall
• Bond C (Straight): Has the most upside potential when rates fall, with no embedded options limiting price appreciation

Strategy Rationale:

• Buying Bond C (straight bond) provides maximum exposure to falling long-term rates
• Selling Bond B (callable bond) benefits because callable bonds have limited upside when rates fall (call risk)
• This strategy creates a spread trade that profits from the relative price movements

Buying Bond A and selling Bond C would not be optimal because both bonds benefit from falling rates, but the straight bond has more upside potential.