Relatively simple question, but came upon it in class and have not been able to come up with an answer:
The two-year bond yield is equal to 4% while the 10-year one is equal to 10%. You want to put on a yield curve flattening trade such that for every 1% flattening you will make a $1000 profit. You can trade 2-year and 10-year 0-coupon bonds at t = 0. For each bond specify, how much you are trading in PV terms and whether you are long or short. (Note: a 1% flattening implies that ∆y10 = ∆y2 - 1%.
My understanding is that since we expect the increase on the 2-year yield to outweigh that of the 10-year yield, we should go long 10-yr while shorting 2-yr. The initial investment would have a net value of 0, since we would fund our investment in the 10-year bond by borrowing at the 2-year rate. But how would we determine the amount allocated to each bond?