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:
- Carry trades may or may not involve a maturity mismatch.
- Carry trades require two yield curves with substantially different slopes.
- 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:
- Inter-market trades should be assessed based on currency-hedged returns.
- Anticipated changes in yield spreads are the primary driver of inter-market trades.
- 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
Floating | Fixed Rate with Semi-annual Payments | |||||
6 Mo Libor | 1 Yr | 2 Yr | 3 Yr | 4 Yr | 5 Yr | |
Mexico | 7.10% | 7.15% | 7.20% | 7.25% | 7.25% | 7.25% |
Greece | — | 3.30% | 5.20% | 5.65% | 5.70% | 5.70% |
Euro | 0.15% | 0.25% | 0.30% | 0.40% | 0.50% | 0.60% |
UK | 0.50% | 0.70% | 0.80% | 0.95% | 1.00% | 1.10% |
US | 1.40% | 1.55% | 1.70% | 1.80% | 1.90% | 1.95% |
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?
- Statement I
- Statement II
- Statement III
Q. Which of Winslow’s statements about inter-market trades is incorrect?
- Statement IV
- Statement V
- 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:
- 0.275%.
- 0.85%.
- 0.90%.
Q. Considering only the US, UK, and Euro markets, the most attractive duration-neutral, currency-neutral carry trade could be implemented as:
- Buy 3-year UK Gilts, Sell 3-year German notes, and enter a 6-month FX forward contract to pay EUR/receive GBP.
- 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.
- 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
- buying the Mexican 5-year in each of the portfolios and hedging it into the base currency of the portfolio.
- 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.
- 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
- buying the Greek 5-year in each portfolio and hedging it into Pesos.
- buying the Greek 5-year in each portfolio and hedging it into USD.
- 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.
The solution to Question 1:
It is always unfortunate that even the best of practitioners or authors do not make the best teachers. The language written in the reading as well as the language written above is opaque. To ensure that, you understand it 100%, I will have to carry out numerical exposition.
Case 1: Intra-Market Carry Trade – There has to be a maturity mismatch
The yield Curve of INR is upward sloping.
1 year Spot rate = 6%
10 year Spot rate = 7%
Hence, 9 year forward rate after 1 year = (((1.07)^10/(1.06))^(1/9))-1 = 7.112% approx.
Imagine a 1 year and 10-year ZCB of FV 1000 each.
Price of 1-year ZCB = 1000/1.06=943.40 approx
Price of 10 year ZCB = 1000/(1.07)^10=508.35
We short 1-year ZCB and Invest in 10-year ZCB. Of course, to make figures compatible, we assume fractional securities are allowed and hence, invest in 943.4/508.35 =1.85581 number of 10-year ZCBs such that Net Cashflow is 0, to begin with. Hope you are understanding that we are borrowing at a 1-year interest rate of 6% and investing the same amount at the 10-year interest rate of 7%.
Scenario 1: Pure Expectation Theory (PET) holds good. This means Spot rates evolve as per the Forward Rate.
So, 9-year spot rate after 1 year = 7.112%
Outflow after 1 year on account of 1-year bond that was shorted = 1000
The Price of the 10-year bond after 1 year = 1000/(1.07112)^9 = 538.84
Hence, Sale Proceeds of 1.85581 number of 10-year bonds = 1.85581*538.84= 1000
Hence, this is a complete Breakeven situation.
Conclusion – In the case of Intra-Market Carry Trade ( Which is obviously Maturity Mismatched), there will be breakeven ( which means no profit no loss), if spot rates evolve as per the forward rates.
Note: This was done in CFA Level 2 Fixed Income: First Chapter.
Case 2: Inter-Market Carry Trade ( No maturity Mismatch)
1 year USD Interest Rate = 1%.
1 year INR Interset Rate = 6%.
Spot Rate right now (S0) = Rs.70/$
Hence, as per Covered IRP –
1-year Forward Rate = 70*(1.06/1.01) = 73.46535
Inter Market Carry Trade ( with no maturity mismatch ) is a bet against Covered IRP. In other words, we believe that the Spot Exchange Rate after 1 year ( S1) will not be equal to the Forward Rate.
However, if Spot Exchange rate after 1 year happens to be equal to forward rate, there will be no arbitrage as shown below.
Step 1 – Borrow $1000 at 1% per annum for 1 year. So, Outflow after 1 year = 1010.
Step 2 – Sell $1000 Spot at 70 to get Rs.70000.
Step 3 – Invest Rs. 70000 at 6% per annum for 1 year, getting 70000*(1.06) = 74,200.
Step 4 – Sell Rs. 74,200 after 1 year at the then Spot Rate assumed to be 73.46535 above. Hence, we get, 74,200/73.46535 = $1010. So, there is no arbitrage.
Conclusion for the purpose of the question – There would be breakeven in the case of Intermarket carry trade, without maturity mismatch if spot exchange rate emerges as per forward rate.
Case 3: Inter-Market Carry Trade ( No maturity Mismatch)
1 year USD Interest Rate = 1%.
1 year INR Interset Rate = 6%.
10 year INR Interest Rate = 7%.
Hence, 9-year forward rate after 1 year =7.112%
Spot Rate right now (S0) = Rs.70/$
Hence, as per Covered IRP –
1-year Forward Rate = 70*(1.06/1.01) =73.46535
Inter Market Carry Trade ( with maturity mismatch ) is a bet against Covered IRP and PET. In other words, we believe that the Spot Exchange Rate after 1 year ( S1) will not be equal to the Forward Rate of 73.46535 and we further believe that the 9-year interest rate after 1 year will not be equal to the 9-year forward rate of 7.112%
Since we want to show breakeven, we will assume that after 1 year –
S1(Exchange Rate) = Forward Rate = 73.46535
9-year spot interest rate, after 1 year = Current Forward Rate = 7.112%
Step 1 – Short sell 1 year USD ZCB at a price = 1000/1.01 = $990.099. Hence, Outflow after 1 year = $1000.
Step 2 – Sell $ 990.099 Spot at 70 to get Rs 69306.93
Step 3 – Invest Rs 69306.93 to buy a number of 10-year Rupee ZCB’s.
Price of 10 year Rupee ZCB today = 1000/(1.07)^10 = Rs 508.35
Therefore, the number of Rupee ZCB purchased today = 69306.93/508.35=136.33703 number of bonds.
Step 4 – Price of the 10-year Rupee ZCB after 1 year = 1000/(1.07112)^9 =
Rs 538.84
Hence, Sale Proceeds =136.33703*538.84=Rs 73463.34
Step 5 – Sell Rs 73463.34 after 1 year at the then Spot Rate i.e. S1 = 73.46535 to get $1000.
This is the same as the Dollar outflow of 1000 in Step 1.So break even.
Conclusion for the purpose of the question – There would be breakeven in the case of Intermarket carry trade, with maturity mismatch if –
Condition 1: Spot Interest Rates in the Future evolves as per the Forward Rate, i.e. PET holds good in the Money Market.
Condition 2: Uncovered IRP Holds Good, i.e. Spot Exchange Rate, later on, is equal to the forward Exchange Rate today, which means PET holds good in the currency market.
Now, let us revisit the 3 statements :
Statement 1 – Carry trades may or may not involve a maturity mismatch. : This is true as shown above in the 3 cases.
Statement 2 – Carry trades require two yield curves with substantially different slopes: This is False, as intra-market carry trade will have only one yield curve as in case 1. Even when 2 yield curves are there like Case 2 and Case 3, the slope of the yield curve is irrelevant for the purpose of evaluating the possibility of breakeven.
Statement 3 – Inter-market carry trades just break even if both yield curves move to the forward: This is not true, because, there are 2 conditions to ensure breakeven as detailed in Case 3 above rates
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 3:
It’s already given that the Carry Trade will be via “Extending Duration”, which in turn means that we will borrow for 6 months and Invest for 5 Years.
Option 1 – We can go for Intra Market Carry Trade in the US, in which we are borrowing 6 months at 1.4%, and investing at 1.95%, earning 0.55%/2 ( Semi-annual Payments), i.e. 0.275%. There is no currency effect, because, it’s intra-market.
Option 2 – We can borrow USD 6 month at 1.4%, Invest at 5 year GBP at 1.1%, therefore, losing 0.3%/2, that is 0.15%. However, since, USD is going to depreciate by 1% against Euro and the Exchange rate between Pound and Euro will remain constant, the same implies that USD will also depreciate against Pound by 1%. Hence, there is a currency gain of 1%, which offsets the 0.15% loss. Hence, the Net Gain is 0.85% – Better than Option 1 ( 0.275%)
Option 3 – We can borrow 6 month Euro at 0.15% and invest in 5 year USD at 1.95%, earning 1.8%/2 = 0.9%. However, since, USD is going to depreciate by 1%, we lose 1% in Currency, such that our net return is only -0.1% as compared to 0.9% given in option C.
Therefore we choose Option 2 ( Option B) as it gives the highest return.
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 5:
Let’s analyze all the options.
Option B : 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.
Breaking it down, gives us 3 parts :
Investment in Greece ( with USD as base ; using USD as the funding currency and investing in Greek Bond) :
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 unhedged, gain via appreciation of Euro = 1%. Hence, total gain = (2.15 + 1)% = 3.15%.
Investment in Greece ( with GBP as base ; using GBP as the funding currency and investing in Greek Bond) :
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 Euro Forward =(0.5-0.15)% = 0.35% Hence, total gain = (2.6 + 0.35)% = 2.95%.
Investment in Greece ( with Euro as 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%. That’s it, since the currency of Greece is Euro only.
Hence, Total Gain = (3.15+2.95+2.775)% = 8.875%.
Option A : Buying the Mexican 5-year in each of the portfolios and hedging it into the base currency of the portfolio.
Since, Mexican yields are expected to decline to 7.0% at all maturities, the price of the Mexican Bonds at the end of the period will be : PMT – 7.25/2 = 3.625, FV – 100, n – 9 ( since we are standing at 0.5^{th} year), i/y – 7/2 = 3.5, CPT PV – 100.95. Hence, Capital Gain = (100.95/100-1) : 0.95%. So, there will be a Capital Gain component while investing in the Mexican bonds whose yields are expected to decline to 7%, as against other Bonds, whose yields are expected to remain unchanged.
Following the same steps as Option B,
Investment in Mexico ( with USD as base ; using USD as the funding currency and investing in 5 Year Mexican Bond) :
Yield differential earned on investing in the 5 Year Mexican bond, funding with USD 6m Libor : (7.25-1.4)/2 = 2.925%. The capital Gain component on the Mexican bond = 0.95%. Since the position is hedged, loss via premium on USD Forward =(7.1-1.4)/2% = 2.85% Hence, total gain = (2.925+0.95 – 2.85)% = 1.025%.
Investment in Mexico ( with GBP as base ; using GBP as the funding currency and investing in 5 Year Mexican Bond) :
Yield differential earned on investing in the 5 Year Mexican bond, funding with GBP 6m Libor : (7.25-0.5)/2 = 3.375%. The capital Gain component on the Mexican bond = 0.95%. Since the position is hedged, loss via premium on GBP Forward =(7.1-0.5)/2% = 3.3% Hence, total gain = (3.375+0.95 – 3.3)% = 1.025%.
Investment in Mexico ( with Euro as base ; using Euro as the funding currency and investing in 5 Year Mexican Bond) :
Yield differential earned on investing in the 5 Year Mexican bond, funding with Euro 6m Libor : (7.25-0.15)/2 = 3.55%. The capital Gain component on the Mexican bond = 0.95%. Since the position is hedged, loss via premium on Euro Forward =(7.1-0.15)/2% = 3.475% Hence, total gain = (3.55+0.95 – 3.475)% = 1.025%.
Hence, Total Gain = (1.025-1.025-1.025)% = 3.075%.
Option C : 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.
Similarly, analyzing Option C :
Investment in Greece ( with Euro as base ; using Euro as the funding currency and investing in 5 Year Mexican Bond) : 2.775% ( as calculated above)
Investment in Mexico ( with GBP as base ; using GBP 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 GBP 6m Libor : (7.25-0.5)/2 = 3.375%. The capital Gain component on the Mexican bond = 0.95%. Since the position is unhedged, loss due Peso depreciating 2% against Euro ( Euro vs GBP remaining constant, hence, a depreciation of 2% against GBP as well), would result in a total gain of (3.375+0.95 – 2)% = 2.325%.
Investment in Mexico ( with USD as 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 : (7.25-1.4)/2 = 2.925%. The capital Gain component on the Mexican bond = 0.95%. Since the position is unhedged, loss due Peso depreciating 1% against USD (Peso will depreciate 2% against Euro and USD will depreciate 1% against Euro), would result in a total gain of (2.925+0.95 – 1)% = 2.875%.
Hence, Total Gain = (2.775+2.325+2.875)% = 7.975%.
Hence, out of all the Options, Option B gives the highest expected return.
In Option B while we are investing in GBP why haven’t we divided the forward premium by 2.
Shouldn’t the gain via premium be 0.35/2?
I have the same doubt , maybe thats why , the solution did not match while solving in class , considering its a text mistake and was solved correctly in class.
Did you get the answer to your question?
In fact for option A, we can apply a shortcut
We are hedging the currency so just focus on investing currency spread(Mexico) (5yrs and 6 months)
i.e. (7.25-7.1)/2 = 0.075 We will earn in all currency
{Also in it can also been seen like in Euro = (7.25-0.15)/2 minus the hedging (7.1 – 1.5)/2}
{In UK = (7.25 – 0.5)/2 minus hedging (7.1 – 0.5)/2}
{ In US = (7.25 – 1.4)/2 minus hedging (7.1 – 1.4)/2}
and just add capital gain yield of 0.95 to each of them we get 3.075
i.e. (0.075 +0.95)3 = 3.075
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.
In Option B, when we are borrowing 6m USD and investing in 5 year Greek. And then hedging the same by selling forward Greek into USD, then why aren’t we incorporating Gain via Forward Prem on Euro against USD ( Euro and Greek same currency) alongwith the return of 2.15% ?
I have the same question, did you get an answer?
really good explanation given. Revisiting this question after 2 months still not getting it completely.