Solution
Justify your response.While the precise G-spreads for bonds X, Y, and Z cannot be readily determined without knowing the yields of other government bonds along the yield curve, it is stated that the yield curve is upward sloping. Based on this fact, the interpolated yield for weighted average durations less than 10 must be less than the yield for the on-the-run 10-year US Treasury, and the interpolated yield for weighted average durations more than 10 must be more than the yield for the on-the-run 10-year US Treasury. Since all three bonds have equivalent benchmark spreads, Bond X will have the lowest G-spread, because the difference between the interpolated yield and bond yield will be lowest for Bond X.
Given that Bond X has the lowest G-spread among the bonds, which have equivalent credit risk from Swanson’s perspective, she will sell Bond X because it is overpriced compared with Bond Y and Bond Z.
