Yield Curve Strategies

The solution to Question 2:

Statement IV: Inter-market trades should be assessed based on currency-hedged returns. This statement is correct

Let us take an example to understand the same better.

Say interest rate on USD (Home Currency) is 2%, on INR is 6% and on BRL is 8%. Now, for an Inter Market trade, we need to borrow in one currency and invest in the other. Therefore, USD is the funding currency and say INR is the investing currency. So, we borrow in USD at 2% and invest in Indian Markets at 6%, the investing currency INR needs to be Forward Sold (hedged), to bring it into USD terms, to determine the return earned through the trade. ( We need to check the return earned on a Covered basis) Same steps to be followed in case of BRL being the investing currency. Hence, statement IV is correct.

Statement V: Anticipated changes in yield spreads are the primary driver of inter-market trades. This statement is correct.

Taking the same example above, let’s suppose we are entering into an inter-market trade, by shorting a ZCB at 2% (USD), and investing the proceeds in Brazil (buying a ZCB) at 8%. Now currently we are standing at an interest rate differential (Yield spread) of 6%. Our return will consist of 3 parts – 1)Net Coupons from the bond ( if these are coupon bearing bonds and not  ZCBs), 2) The Price change on both the bonds which is in turn a function of the change in Yield spread and 3) Change in currency exchange rate.(which is not the focus of this statement) Now, considering the short-trading horizon of active carry trade strategies, the Coupons components are near negligible ( if these are ZCBs, there is no coupon component). Hence, the only component that we are betting on is the Price change or the interest rate differential. Here in the example, we expect the spread to narrow ( say 4%; the USD interest rate increased to 3% and the BRL interest rate decreased to 6%). The same will result in a profitable position. Hence, to conclude, Anticipated changes in yield spreads are the primary driver of inter-market trades. Therefore, statement V is correct.

Statement VI: Whether a bond offers a relatively attractive return depends on both the portfolio’s base currency and the currency in which the bond is denominated. This statement is INCORRECT.

Due to Covered Interest Arbitrage, the relative attractiveness of bonds does not depend on the currency into which they are hedged for comparison. Hence, the ranking of bonds does not depend on the base currency of the portfolio.

The solution to Question 4:

In Option A , we are of course enjoying the interest rate differential, however, that differential is getting offset by the Forward Differential, as per Covered IRP, because we are supposed to be Currency Neutral. Hence, there is no scope of any return from both Option A.

The explanation given in the Candidate Resource for Option C is Optimum and I cannot improve upon the same. I would just like to add that –

Synthetic Long Futures ( F+) = Long Spot (S+) and Rf Borrowing.

Synthetic Short Futures( F-) = Short Spot(S-) and Rf Investing.

In the light of this, you may interpret the explanation given in the Candidate Resource reproduced below :

This combination of futures positions does create a duration-neutral, currency neutral carry trade, but it is not the highest available carry. Since the T-note futures price reflects the pricing of the 5-year note as cheapest to deliver, the long position in this contract is equivalent to buying the 5-year Treasury and financing it for 6 months. This generates net carry of 0.275% = (1.95% – 1.40%)/2. Similarly, the short position in the German note futures is equivalent to being short the 5-year German note and lending the proceeds for 6 months, generating net carry of –0.225% = (0.15% – 0.60%)/2. The combined carry is 0.05%, half of what is available on the position in B

Let us understand Option B via a diagram. ( Refer to the diagram attached)

The Swap arrangement is Duration Neutral, because, according to the arrangement, we are supposed to receive 3 years GBP interest rate( Swap 1), which is our asset and at the same time, we are supposed to pay 3 Year Interest on Euro ( Swap 2), which is our liability. Hence, there is duration neutrality. Similarly, considering the other legs, we have a liability of 6 month from Swap 1 ( we are supposed to pay 6m Libor on GBP) and at the same time, we have an asset of 6 months from Swap 2 ( we are supposed to receive 6-month Libor on Euro).

The Swap arrangement is Currency Neutral, because, in the arrangement, if we are Long on GBP, via 3-year bond, we are also short on GBP via the 6 month Bond. Same for Euro legs.

The solution to Question 6:

Let’s analyze all the options.

Option A. Buying the Greek 5-year in each portfolio and hedging it into Pesos.

Breaking it down, we get

Investment in Greece ( with USD as a base; using USD as the funding currency and investing in 5 Year Greek Bond, and hedging via Peso) :

Yield differential earned on investing in the 5 Year Greek bond, funding with USD 6m Libor : (5.7-1.4)/2 = 2.15%. Since the position is hedged, gain via premium on Peso Forward =(7.1-0.15)/2% = 3.475%. Again, we are exposed to Peso, therefore, loss due to Peso depreciation against USD =1% Hence, total gain = (2.15+3.475-1)% = 4.625%.

Investment in Greece ( with the UK as a base; using GBP as the funding currency and investing in 5 Year Greek Bond and hedging via Peso)

Yield differential earned on investing in the 5 Year Greek bond, funding with GBP 6m Libor : (5.7-0.5)/2 = 2.6%. Since the position is hedged, gain via premium on Peso Forward =(7.1-0.15)/2% = 3.475%. Again, we are exposed to Peso, therefore, loss due to Peso depreciation against GBP =2% Hence, total gain = (2.6+3.475-2)% = 4.075%.

Investment in Greece ( with Euro as a base; using GBP as the funding currency and investing in 5 Year Greek Bond and hedging via Peso)

Yield differential earned on investing in the 5 Year Greek bond, funding with Euro 6m Libor : (5.7-0.15)/2 = 2.775%. Since the position is hedged, gain via premium on Peso Forward =(7.1-0.15)/2% = 3.475%. Again, we are exposed to Peso, therefore, loss due to Peso depreciation against Euro =2% Hence, total gain = (2.775+3.475-2)% = 4.25%.

Hence, Total Gain = (4.625+4.075+4.25)% = 12.95%.

Option B: Buying the Greek 5-year in each portfolio and hedging it into USD.

Breaking it down gives us 3 parts :

Investment in Greece ( with USD as a base; using USD as the funding currency and investing in Greek Bond, and hedging via USD) :

Yield differential earned on investing in the 5 Year Greek bond, funding with Euro 6m Libor : (5.7-1.4)/2 = 2.15%.

Investment in Greece ( with GBP as a base; using GBP as the funding currency and investing in Greek Bond and hedging via USD) :

Yield differential earned on investing in the 5 Year Greek bond, funding with GBP 6m Libor : (5.7-0.5)/2 = 2.6%. Since the position is hedged, gain via premium on GBP Forward =(1.4-0.15)/2% = 0.625%. Again, we are exposed to USD, therefore, loss due to USD depreciation against GBP =1% Hence, total gain = (2.6 +0625-1)% = 2.225%.

Investment in Greece ( with Euro as a base; using Euro as the funding currency and investing in Greek Bond) :

Yield differential earned on investing in the 5 Year Greek bond, funding with Euro 6m Libor : (5.7-0.15)/2 = 2.775%. Since the position is hedged, gain via premium on Euro Forward =(1.4-0.15)/2% = 0.625%. Again, we are exposed to USD, therefore, loss due to USD depreciation against Euro =1% Hence, total gain = (2.775 +0625-1)% = 2.4%.

Hence, Total Gain = (2.15+2.225+2.4)% = 6.775 %.

Option C : Buying the Mexican 5-year in each portfolio and not hedging the currency.

.Similarly, analyzing Option C :

Investing in the Mexican bond will generate a Capital Gain Yield of 0.95%

Investment in Mexico ( with USD as a base; using Euro as the funding currency and investing in 5 Year Mexican Bond and leaving positions unhedged): 2.875% ( as calculated above)

Investment in Mexico ( with GBP as a base; using GBP as the funding currency and investing in 5 Year Mexican Bond, keeping the position unhedged.) = 2.325%

Investment in Mexico ( with Euro as a base; using USD as the funding currency and investing in 5 Year Mexican Bond, keeping the position unhedged.

Yield differential earned on investing in the 5 Year Mexican bond, funding with USD 6m Libor : (7.25-0.15)/2 = 3.55 %. The capital Gain component on the Mexican bond = 0.95%. Since the position is unhedged, loss due to Peso depreciating 2% against the Euro would result in a total gain of (3.55+0.95 – 2)% = 2.5%.

Hence, Total Gain = (2.325+2.875+2.5)% = 7.7%.

Hence, out of all the options, Option A gives the highest expected return.