Answer: Buy interest-only (IO) strips from mortgage-backed securities

## Explanation **Understanding Negative Duration:** - **Duration** measures the sensitivity of a bond's price to changes in interest rates. - **Positive duration** means bond prices decrease when interest rates rise (typical for most bonds). - **Negative duration** means bond prices increase when interest rates rise. **Analysis of Options:** - **A. Inverse floaters**: These have higher duration than regular floaters but still typically have positive duration. - **B. Callable bonds**: These have positive duration (though modified duration may be lower due to embedded call option). - **C. Interest-only (IO) strips**: These are mortgage-backed securities where the investor receives only the interest payments. When interest rates rise, prepayments slow down, extending the life of IO strips and increasing their value - giving them negative duration. - **D. Putable bonds**: These have positive duration (though modified duration may be lower due to embedded put option). **Correct Answer: C** IO strips from mortgage-backed securities exhibit negative duration because: - When interest rates rise, mortgage prepayments decrease - This extends the life of the IO strip, increasing the total interest payments received - The increased cash flow duration outweighs the discounting effect, resulting in price appreciation when rates rise This makes IO strips an effective tool for hedging against rising interest rates in a portfolio.

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