Answer: long a putable bond and short an otherwise similar straight bond.

## Explanation The correct strategy is to go **long a putable bond and short an otherwise similar straight bond**. **Scenario Analysis:** - **Yield curve steepening due to increase in long-term rates** means long-term rates are rising while short-term rates remain relatively stable - When long-term rates increase, bond prices decrease **Strategy Rationale:** - **Long Putable Bond:** When rates rise, the embedded put option becomes more valuable as it provides downside protection. Bondholders can put the bond back to the issuer at the predetermined price, limiting losses compared to straight bonds. - **Short Straight Bond:** When rates rise, straight bonds will decline in price more significantly than putable bonds because they lack the protective put option. **Relative Performance:** - The putable bond will outperform the straight bond in a rising rate environment - The put option acts as insurance against rising rates - This creates a positive spread between the long putable position and short straight position This strategy effectively creates a hedge that profits from the relative outperformance of putable bonds over straight bonds when long-term rates increase.

Author: LeetQuiz Editorial Team