Explanation

When interest rates rise, the market value of existing fixed-income securities (like 10-year Treasury notes) decreases. The portfolio manager has a long position in 10-year Treasury notes, meaning they own these bonds and are exposed to interest rate risk.

To hedge against rising rates, the manager needs to establish a position that will gain value when rates rise to offset the losses on the Treasury notes.

Analysis of Options:

• Option A: Enter into a 10-year pay-fixed and receive-floating interest rate swap

  • In this swap, the portfolio manager pays a fixed rate and receives a floating rate.
  • When interest rates rise, the floating rate payments increase, creating a positive cash flow that offsets the decline in the Treasury notes' value.
  • This is the correct hedge for rising rates.

• Option B: Enter into a 10-year receive-fixed and pay-floating interest rate swap

  • This would increase exposure to rising rates, as the manager would be paying higher floating rates while receiving fixed rates.
  • This would worsen the position's risk.

• Option C: Establish a long position in 10-year Treasury note futures

  • A long futures position would also lose value when rates rise, as bond prices fall.
  • This would increase rather than reduce the exposure to rising rates.

• Option D: Buy a call option on 10-year Treasury note futures

  • A call option gives the right to buy at a fixed price, which benefits when bond prices rise (rates fall).
  • This would not protect against rising rates and would be costly if rates continue to rise.

Key Concept:

The portfolio manager is effectively long duration (sensitive to rising rates). To hedge this, they need to take a short duration position. A pay-fixed swap creates negative duration exposure, which offsets the positive duration of the Treasury notes.