Explanation:
All three guidelines proposed by Paula Sigel are incorrect in the context of identifying the cheapest-to-deliver bonds. The correct rules are as follows:
I. When the yield is greater than 6%, the cheapest-to-deliver bonds tend to be low-coupon bonds with longer maturities. This is because when yields are high, investors prefer bonds that pay less interest over a longer period, as they can reinvest the proceeds at higher rates.
II. When the yield is less than 6%, the cheapest-to-deliver bonds tend to be high-coupon bonds with shorter maturities. This is because when yields are low, investors prefer bonds that pay more interest over a shorter period, as they can reinvest the proceeds at higher rates when they become available.
III. When the yield curve is upward sloping, the cheapest-to-deliver bonds tend to have longer maturities. This is because an upward-sloping yield curve indicates that long-term interest rates are higher than short-term rates, making longer-maturity bonds more attractive to deliver.
IV. When the yield curve is downward sloping, the cheapest-to-deliver bonds tend to have shorter maturities. This is because a downward-sloping yield curve indicates that short-term interest rates are higher than long-term rates, making shorter-maturity bonds more attractive to deliver.
Choice A is incorrect. Statement III is indeed incorrect, but statements I and II are also incorrect, which makes choice A wrong.
Choice B is incorrect. While it correctly identifies that statements I and II are incorrect, it fails to recognize that statement III is also not accurate in identifying the cheapest-to-deliver bonds.
Choice C is incorrect. This option incorrectly assumes that statement I is correct while statements II and III are not. In reality, all three statements proposed by Sigel are inaccurate in determining the cheapest-to-deliver bonds.
Choice D is correct. This option correctly identifies that all three guidelines proposed by Sigel for identifying the cheapest-to-deliver bonds are inaccurate.
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Q-697 Paula Sigel is the head of the interest rate futures unit of Thomson Investment Company. Thomson has traditionally only invested in equities and currencies, but it has recently set up a new division that only focuses on the investments in futures contracts on Treasury bonds. It has come to Paulina's attention that due to a lack of familiarity with derivatives trading, her team is having difficulty determining the cheapest to deliver bonds. To overcome this difficulty, Sigel came up with the following guidelines to better identify the cheapest-to-deliver bonds:
I. When the yield is greater than 6%, the cheapest-to-deliver bonds tend to be low-coupon with shorter maturities
II. When the yield is less than 6%, the cheapest-to-deliver bonds tend to be high-coupon with longer maturities
III. When the yield curve is upward sloping, the cheapest-to-deliver bonds tend to have shorter maturities
Determine which of Paula's statements is/are incorrect.
A
Only statement III is incorrect.
B
Only statements I and II are incorrect.
C
Only statements II and III are incorrect.
D
Statements I, II, and III are all incorrect.