Yield Curve Strategies

Susan Winslow manages bond funds denominated in US Dollars, Euros, and British Pounds. Each fund invests in sovereign bonds and related derivatives. Each fund can invest a portion of its assets outside its base currency market with or without hedging the currency exposure, but to date Winslow has not utilized this capacity. She believes she can also hedge bonds into currencies other than a portfolio’s base currency when she expects doing so will add value. However, the legal department has not yet confirmed this interpretation. If the lawyers disagree, Winslow will be limited to either unhedged positions or hedging into each portfolio’s base currency.

Given the historically low rates available in the US, Euro, and UK markets, Winslow has decided to look for inter-market opportunities. With that in mind, she gathered observations about such trades from various sources. Winslow’s notes with respect to carry trades include these statements:

1. Carry trades may or may not involve a maturity mismatch.
2. Carry trades require two yield curves with substantially different slopes.
3. Inter-market carry trades just break even if both yield curves move to the forward rates.

Regarding inter-market trades in general her notes indicate:

1. Inter-market trades should be assessed based on currency-hedged returns.
2. Anticipated changes in yield spreads are the primary driver of inter-market trades.
3. 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.

Winslow thinks the Mexican and Greek markets may offer attractive opportunities to enhance returns. Yields in these markets are given in Exhibit 1, along with those for the base currencies of her portfolios. The Greek rates are for euro-denominated government bonds priced at par. In the other markets, the yields apply to par sovereign bonds as well as to the fixed side of swaps versus six-month Libor (i.e., swap spreads are zero in each market). The six-month Libor rates also represent the rates at which investors can borrow or lend in each currency. Winslow observes that the five-year Treasury-note and the five-year German government note are the cheapest to deliver against their respective futures contracts expiring in six months.

Exhibit 1

Sovereign Yields in Five Markets

Winslow expects yields in the US, Euro, UK, and Greek markets to remain stable over the next six months. She expects Mexican yields to decline to 7.0% at all maturities. Meanwhile, she projects that the Mexican Peso will depreciate by 2% against the Euro, the US Dollar will depreciate by 1% against the Euro, and the British Pound will remain stable versus the Euro. Winslow believes bonds of the same maturity may be viewed as having the same duration for purposes of identifying the most attractive positions.

Based on these views, Winslow is considering three types of trades. First, she is looking at carry trades, with or without taking currency exposure, among her three base currency markets. Each such trade will involve extending duration (e.g., lend long/borrow short) in no more than one market. Second, assuming the legal department confirms her interpretation of permissible currency hedging, she wants to identify the most attractive five-year bond and currency exposure for each of her three portfolios from among the five markets shown in Exhibit 1. Third, she wants to identify the most attractive five-year bond and hedging decision for each portfolio if she is only allowed to hedge into the portfolio’s base currency.

Q. Which of Winslow’s statements about carry trades is correct?

1. Statement I
2. Statement II
3. Statement III

Q. Which of Winslow’s statements about inter-market trades is incorrect?

1. Statement IV
2. Statement V
3. Statement VI

Q. Among the carry trades available in the US, Euro, and UK markets, the highest expected return for the USD-denominated portfolio over the next 6 months is closest to:

1. 0.275%.
2. 0.85%.
3. 0.90%.

Q. Considering only the US, UK, and Euro markets, the most attractive duration-neutral, currency-neutral carry trade could be implemented as:

1. Buy 3-year UK Gilts, Sell 3-year German notes, and enter a 6-month FX forward contract to pay EUR/receive GBP.
2. Receive fixed/pay floating on a 3-year GBP interest rate swap and receive floating/pay fixed on a 3-year EUR interest rate swap.
3. Buy the T-note futures contract and sell the German note futures contract for delivery in six months.

Q. If Winslow is limited to unhedged positions or hedging into each portfolio’s base currency, she can obtain the highest expected returns by

1. buying the Mexican 5-year in each of the portfolios and hedging it into the base currency of the portfolio.
2. buying the Greek 5-year in each of the portfolios, hedging the currency in the GBP-based portfolio, and leaving the currency unhedged in the dollar-based portfolio.
3. buying the Greek 5-year in the Euro-denominated portfolio, buying the Mexican 5-year in the GBP and USD-denominated portfolios, and leaving the currency unhedged in each case.

Q. If Winslow is allowed to hedge into any of the currencies, she can obtain the highest expected returns by

1. buying the Greek 5-year in each portfolio and hedging it into Pesos.
2. buying the Greek 5-year in each portfolio and hedging it into USD.
3. buying the Mexican 5-year in each portfolio and not hedging the currency.

Sanjay Sir, Can you please walk me through this item set. This came in practice question in student resources.