What is required to create a butterfly strategy that lowers convexity?

The butterfly strategy designed to lower convexity involves taking positions that have varying durations and sensitivities to interest rate changes. Specifically, the correct choice indicates a strategy that is short a barbell and long a bullet bond.

A barbell strategy consists of holding bonds at the short and long ends of the maturity spectrum, which typically leads to increased convexity because the short and long bonds react differently to interest rate changes. By shorting a barbell, you are effectively reducing the exposure that typically results in higher convexity.

On the other hand, a bullet bond, which has a single maturity point, provides a smoother yield curve behavior. By going long on bullet bonds while shorting a barbell, the overall position will have reduced convexity. This is because the bullet bond's cash flow structure offsets some of the convexity inherent in the barbell strategy, resulting in a net position that has lower overall convexity.

This approach is particularly useful when an investor expects interest rates to remain stable or anticipate a flattening of the yield curve. In such scenarios, reducing convexity through this butterfly strategy can enhance portfolio performance and mitigate risk tied to interest rate volatility.