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A dealer in government securities currently holds $875 million in 10-year Treasury
bonds and $1,410 million in 6-month Treasury bills. Current yields on the T-bonds
average 7.15 percent while 6-month T-bill yields average 3.38 percent. The dealer is
currently borrowing $2,300 million through one-week repurchase agreements at an
interest rate of 3.20 percent. What is the dealer's expected (annualized) carry income?
Suppose that 10-year T-bond rates suddenly rise to 7.30 percent, T-bill rates climb to
5.40 percent and interest rates on comparable maturity RPs increase to 5.55 percent.
What will happen to the dealer's expected (annualized) carry income and why?
Should this dealer have moved to a long position or a short position before the interest
rate change just described? Should the dealer alter his or her borrowing plans in any way? Please explain your answer.

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