Carry Trades

CFA Level III Fixed Income
#1

Online Topic Test that deals with carry trades has this for an answer explanation:

Livera has the swap positions reversed between bunds and Treasuries. Given two upward-sloping yield curves that are both expected to remain stable, an inter-market carry trade can be constructed to avoid currency risk by simultaneously buying and selling both currencies. The choice of the trades depends on which yield curve has the steeper slope, which in this case is the bund yield curve. For swaps, one should receive fixed/pay floating in the steeper market (bunds) and pay fixed/receive floating in the flatter market (Treasuries). For futures, one should take a long position in the futures in the steeper market (bunds) and a short position in the futures in the flatter market (Treasuries).

Why is this? Is it because the steeper the curve, the more the rate drops so you’re floating payment is cheaper each year compared to a flatter curve?

Thanks again

#2

The steeper curve has a greater difference between the long rate and the short rate than the flatter curve does.

#3

does this mean that the floating payments will decrease faster than on a flatter curve?

#4

*increase

#5

The hope is that they won’t change at all.

#6

thanks both for the help

#7

My pleasure.

#8

Hi there,

I am confused about the hedging part which is implied by “avoid taking the currency risk”. Please see the sentence in bold from the question below:

"Livera adds, “Another way to add value to the portfolio in a stable interest rate environment is a carry trade. While there are ways to implement an intra-market (single-currency) carry trade, we recommend an inter-market carry trade with US Treasuries as the other market. The Treasury yield curve is currently flatter than the bund yield curve, and we expect it to remain stable over the coming year. To avoid taking on currency risk, we suggest one of two similar strategies.The first strategy enters into two swap agreements, one to receive fixed/pay floating in the Treasury market and the other to pay fixed/receive floating in the bund market. The second strategy takes a long position in 10-year bund futures and a short position in 10-year Treasury futures.”

Shouldn’t we take the counter positions to hedge against the currency risk, meaning that going long the low yield and short the high yield to be able to hedge currency risk?

#9

https://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91369646

#10

Thank you, much better but still not 100% clear.

Is the swap transaction part of the carry trade or is it a currency hedging transaction? I think it’s not clear from the text.

Does an inter-market carry trade itself naturally hedge the currency exposure via being duration neutral (gaining in the steeper market and losing in the flatter market)? If it is, i understand; if not i still don’t understand why we are not taking the contra position with the swap.