What is a butterfly trade in fixed income, and how is it constructed to express a view on yield curve curvature?

Question

AcadiFi · Accepted Answer

The butterfly trade is one of the most elegant yield curve strategies. It expresses a view on curvature — whether the middle of the curve is cheap or rich relative to the wings. **Construction** A butterfly involves three maturities: - **Wings** (short-term + long-term bonds) - **Body** (intermediate-term bond) | Position | Long Butterfly | Short Butterfly | |---|---|---| | Short-term wing | Long | Short | | Intermediate body | Short | Long | | Long-term wing | Long | Short | | View | Curve will flatten (become less humped) | Curve will steepen (become more humped) | The trade is structured to be **duration-neutral** and often **cash-neutral**, isolating the curvature bet from any directional rate view. **Duration Weighting** The wing positions are sized so that their combined dollar duration equals the body's dollar duration. A common approach uses the 2s/10s/30s butterfly: **Worked Example — Northfield Fixed Income Partners:** Northfield believes the 10-year sector is cheap relative to 2s and 30s (the curve is too humped). They construct a long butterfly: | Leg | Bond | Duration | Par Amount | Dollar Duration | |---|---|---|---|---| | Short wing | 2-year UST | 1.95 | $52M | $1,014,000 | | Body (short) | 10-year UST | 8.40 | ($25M) | ($2,100,000) | | Long wing | 30-year UST | 19.50 | $56M | $1,092,000 | Total dollar duration: $1,014K - $2,100K + $1,092K = ~$6K (approximately neutral). If the yield curve flattens at the belly (10-year yields fall relative to 2s and 30s), the short body position profits as the 10-year price rises. The wing losses are offset by the body gain. **Measuring Curvature — The Butterfly Spread** Butterfly Spread = 2 x (10-year yield) - (2-year yield) - (30-year yield) A positive value means the curve is humped. A long butterfly profits when this spread **decreases**. \`\`\`mermaid flowchart LR A["2Y Wing
LONG"] --- B["10Y Body
SHORT"] B --- C["30Y Wing
LONG"] D["Profit if curve
flattens at belly"] B --> D \`\`\` **Key Exam Points:** 1. A long butterfly is equivalent to a barbell (wings) versus a bullet (body). 2. The trade isolates curvature from level and slope changes when properly duration-matched. 3. Carry and roll-down must be considered — the body often has the highest carry, so a long butterfly typically has negative carry. 4. Butterflies can be constructed at any three points on the curve, not just 2/10/30. Practice curve strategies in our CFA fixed income question bank.

What is a butterfly trade in fixed income, and how is it constructed to express a view on yield curve curvature?

Master Level II with our CFA Course

Related Questions

Practice Questions