Carry

CFA Level III Fixed Income
#1

Hi All,

I was going through the carry and do not quite understand why we receive fixed pay floating in steeper markets and pay fixed receive floating in flatter market?

Should not be the same type of swap in both the markets?

Help will be appreciated.

#2

Is it “steeper” and “flatter”, or “steepening” and “flattening”?

Do you have a page reference?

#3

The text is talking about being duration neutral and currency neutral.

You receive fixed and pay floating on the steep marketing to make money, and then you pay fixed receive floating on the flatter market which causes you to lose some money but keeps you duration neutral. The net return is postive.

#4

magician,

Vol 4 rd 24, page 138 in the curriculum.

125mph,

So you are saying that we need to do both the swaps together? I was thinking it’s a different swap for steeper and different for flatter market?

Thanks .

#5

I will admit I’m still thinking through the answer to your question in a flatter market. In a steeper market though, it’s pretty clear you want to receive fixed and pay floating. This is very similar to what is called “roll down” on a bond (I forget what CFA calls this…rolldown yield maybe?).

Basically the way I think of it is this:

If you enter into a swap receiving fixed, your “carry” is effectively two things: 1) the excess return you get over the floating rate you pay, and 2) how high the current fixed rate you’re receiving is relative to what a swap of that duration would receive in the current market.

Number 1 is pretty clear in terms of how that affects your carry. Number 2 is probably where you are confused. Suppose you enter into a 10y swap receiving fixed of 3%. But let’s say the curve is really steep, and one year later a 9y swap is trading for 1.50%. Your 10y swap has aged one year and is now effectively a 9y swap receiving 3%. You are receiving 1.50% above the market rate for a 9y swap! You could actually lock in a rate of 1.5% without any floating payments by entering into a pay fixed 9y swap at that current rate of 1.50% because the floating payments cancel, you receive 3%, and you pay 1.50%.

You can do this in situations where the curve is flat, but it becomes considerably less profitable relative to the duration risk you are carrying (in a flat rate environment, that 9y swap might trade at 2.90% and you would only earn 10bps in roll down while still wearing the same amount of duration).

I suppose the other poster’s answer regarding flat rate environments makes sense. If you pay fixed on the swap, you’ll lose on carry but because rates are flat, you lose very little but because you’re paying fixed on the swap you’ve reduced your duration. So it’s a cheap way to hedge duration.