Final answer:
Executing a yield pickup swap involves selling existing bonds with a lower yield and purchasing bonds with a higher yield while maintaining a similar credit quality and maturity. The correct option is 2.
Step-by-step explanation:
If you are selling 10-year, A-rated 7 percent bonds that are yielding 8 percent and replacing them with an equal amount of 10-year, A-rated 8 percent bonds that are priced to yield 9 percent, you are executing a yield pickup swap. A yield pickup swap is a strategy used by investors to increase their yield on investments without increasing the risk by a significant amount. By selling the existing bonds with a lower yield and purchasing bonds with a higher yield, an investor is able to pick up additional yield on their investment while maintaining a similar credit quality and maturity.
The bond prices and yields have an inverse relationship. This means when interest rates rise, bonds issued at lower interest rates are worth less, and when interest rates fall, bonds issued at higher interest rates increase in value. In our case, the investor is swapping out bonds with lower yields for bonds with a higher coupon rate in an environment where the yields on bonds are even higher, capturing the spread between the bond's own yield and the market yield.
The provided information on yield, total return, and the changing prices of bonds based on prevailing interest rates assists in understanding the impact of interest rate changes on bond prices and why a yield pickup swap can be beneficial. To reiterate, when selling a bond before maturity, the yield can reflect both the interest payments you receive and any capital gains or losses that are realized. The coupon rate remains constant, but the selling price of a bond can fluctuate with market interest rates.