Carry Trade

CFA Level III Fixed Income
#1

In order to eliminate currency exposure in an inter-market trade, the investor must, explicitly or implicitly, both borrow and lend in each currency. The essence of this trade is to exploit differences in the slopes of the two yield curves rather than the difference in overall rate levels. The idea, assuming normal, upward sloping yield curves, is to lend at the long end and borrow at the short end on the relatively steep curve, and to lend at the short end and borrow at the long end on the relatively flat curve. Among the ways to implement this trade are the following:

  • Receive fixed/pay floating in the steeper market and pay fixed/receive floating in the flatter market.
  • Take a long position in bond (or note) futures in the steeper market and a short futures position in the flatter market.

Question: 1: I understand why lend at the long end and borrow at the short end on the relatively steep curve. Because yield curve is upward sloping, long end yield is greater than short end yield. But why lend at the short end and borrow at the long end on the relatively flat curve? I think, as long as the yield curve is upward sloping(no matter it is relatively steep or flat), we should always lend at the long end and borrow at the short end.

2: “Take a long position in bond (or note) futures in the steeper market and a short futures position in the flatter market.” Why? What does it mean?

#2

As I see, in a flatten yield curve market you can access to long-term rates almost as cheap as the short-term ones, so borrow at long end and lend at the short end (lower credit risk relative to profit).

Suppose you want to buy a house for 500K and also suppose you are able to borrow at short terms and long terms for this purchase.

If you are provided with 3-month revolving loans for 500K at 5% annual rate, or a mortgage for 500K at 8% annual rate. What financing would you take? I would go for the 3-m revolving loans and save 3% on interest expense.

Suppose now that mortgages are offered just at 5% annual rate. You would take the mortgage this time… You borrow at long end and will lend at short end in this flatten curve.