A flat curve, a steep curve, and a butterfly trade all start with the same forward rates. The exam tests whether you can read the curve, identify the divergence from market-implied pricing, and pick the position that monetizes the view.
A bond's total return over a holding period decomposes into five components. The exam expects you to name and sign each one.
Coupon income is the contractual cash flow, independent of yield moves. Rolldown return captures the price gain as a bond ages along a static, upward-sloping curve and trades at a lower yield. Price change from yield shift captures the duration and convexity response to actual rate moves. Reinvestment income is the return on coupons reinvested at prevailing rates. Currency return appears for non-base-currency bonds.
The first-order approximation for total return when yields shift:
When yields fall, duration contributes positively and convexity adds a second-order boost. When yields rise, duration hurts but convexity still adds a positive cushion (convexity is always non-negative for option-free...
Common mistakes
- Confusing spot rates with forward rates as the benchmark. Forwards are the break-even. Profit requires divergence from forwards, not from spot. Trap: claiming "the 10y will rise to 4.65%" matches forwards and so a steepener earns positive carry. The carry is zero if forwards realize.
- Sizing curve trades by face value instead of DV01. A $10M 2y vs. $10M 10y is not curve-neutral; the 10y has roughly 4x the DV01. Trap: assuming equal notionals neutralize level risk.
- Treating barbells as free convexity. Barbells give up 5 to 15 bps of yield vs. bullets. The convexity only pays if realized rate moves or volatility exceed implied. Trap: holding a barbell in a flat-vol environment.
Bottom line
- Forward rates are the market's break-even. Profit only if your realized rate path diverges from forwards, not from spot.
- Total return decomposes into yield income, rolldown, duration, convexity, reinvestment, and FX; each component signs independently.
- Level, slope, and curvature are the three independent curve risks; duration handles level, 2s10s handles slope, butterflies and bullet/barbell handle curvature.
- Key rate durations sum to effective duration but decompose exposure tenor by tenor; comparing benchmark KRDs vs. portfolio KRDs reveals the curve bet.
Exam shortcut
When a vignette gives forward rates and an interest rate view, subtract forwards from the view first. Positive difference (view above forwards) means shorten duration; negative means extend. The sign of the divergence resolves the position.
The full lesson (about 3,748 words, 25 min read) adds 8 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- yield curve strategies
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