Kuaminika Capital Management Case Scenario
Ivankiv offers another recommendation: “Our analysts believe both Australian and British long-term yields will decline more than long-term German yields over the coming year, with Australian long-term yields falling the most by a wide margin. The British yield curve is more steeply sloped than the Australian. Rather than remain invested in bunds, Kuaminika could invest in either British gilts or Australian government bonds and hedge the currency risk back to the euro with a rolling three-month foreign currency forward. There are, however, some issues to keep in mind:
- Issue 1: The British gilt market is likely better for investment because its steeper yield curve provides larger benefits from ‘riding the curve.’
- Issue 2: In order to properly account for the cost/benefit of eliminating currency exposure, hedge gains or losses should be measured relative to forward foreign exchange rates.
- Issue 3: The rolling hedge will generate a profit (loss) if the spread between the short-term German yield and the short-term Australian or British yield increases (decreases) over time.”
If all long-term rates fall as expected, which of Ivankiv’s issues regarding investment in the British gilt or Australian Treasury markets is least likely correct in the context of an inter-market trade?
- Issue 1
- Issue 2
- Issue 3
Can someone explain the rationale behind the answer. It is taken from topic area question
So, in this question Issue 2 is completely correct as the hedge gain or losses should be measured after considering the cost or benefit of eliminating currency exposure.
Now, comes checking Issue 1 & Issue 3.
Issue 3 wording is not crystal clear as they have not mentioned which short term rate is increasing i.e. UK/Aussie or Euro when they say spread is increasing. It is kind of assumed that euro rate will increase vis vis the UK or Aussie.
For issue 3, let’s choose only German bond(euro) & UK (same as AU) to start with.
Position is: long UK bond -> exposure to UK currency -> to hedge currency risk, need to sell UK & Buy Euro currency: for the hedge position we will receive Euro rate & pay UK rate.
Rolling hedge means when the old hedge position expire, we buy same new hedge position to maintain the hedge.
If the Spread between German(Euro) & UK rate increase -> Euro rate increases, UK rate decrease -> the new created hedge position will receive higher Euro rate & pay lower UK rate
Thus it is a profit.
Now, for Issue 1, we know from the question that Aussie govt. yield will fall the most by wide margin, so its more beneficial to go long that rather than gilts.