I am finding the carry trade questions in fixed income difficult. Any suggestion on how to go about learning this before the exam?
In particular the questions in the curriculum - question 23 to 30 (yield curve strategies)
Keep it simple. How Bond/FX/PE guys/gals make money is they borrow cheap and invest it a higher yielding instrument/vehicle.
For the Carry Trade, especially in Currency Carry Trades, recognize that one interest rate is yielding higher than the other, so to profit from that, borrow in the lower yielding currency, convert to the higher yielding currency at the spot rate, invest it for a period, convert back, pay back what you borrowed plus interest, keep spread.
ex) Say the BRL/USD spot rate is 2.41 and BRL’s interest rate is 6% and the USD’s interest rate is 1%. Per the Covered Interest Rate Parity, the difference in the spot and forward rates, should be the difference between the two interest rates of the two currencies. Knowing this, the implied one-year forward rate is 2.41 x (1.06 / 1.01) = BRL/USD 2.529.
Because you know that the 6% yielding BRL will converge closer to the 1% USD, you want to borrow in USD and invest in the BRL now. The reason for this is because the yield is high, it implies the price is low. This means that BRL is trading at a ‘forward discount’ because the price will eventually rise over time as the yield comes down. So what do we do to take advantage of this?
- BORROW lower yielding FX. Say, Borrow $100 USD @ 1% (meaning you have to pay back $101 at the end).
- CONVERT into higher yielding FX at current spot price. $100 x BRL/USD 2.41 = BRL/USD 241
- INVEST converted FX @ current, higher yield for the period. BRL/USD 241 x 1.06 = BRL/USD 255.46
- CONVERT back to funding FX at current, unchanged spot rate. 255.46 x 1 / 2.41 = $106
- Pay back borrowed amount + interest. $106 - $101 loan (principal + interest) = $5 profit.
I would suggest u dedicate your effort to other materials coz it was badly written and some prep providers even can’t explain it well.
Also chances of it being tested deeply is very low bcos it’s a new material. Knowing the basics such as lending long and borrowing short on the steepest curve and also lending short and borrowing long on the flattest curve should suffice for this exams.
Most of the mocks I’ve taken even don’t have much questions on them.
orrrrr you can just stick with Buy Low Price (Buy Higher Yield) by Selling High Price (Selling Lower Yield)!
On the same topic, reading 20 EOC 25, I understand that, we compute the ‘carry component’ of a loss of .15% over 6 months, then we take into account the GBP appreciation over USD.
The text states 1% increase of GBP over USD. It does not explicitly mention the timeframe in my opinion.
Question: why does the CFAI add 1% for the FX appreciation, and not 0.5% for the 6 months period?
It was indicated that the horizon was over six months.
“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.”
So, over the six months, US dollars is expected to depreciate by 1% against the Euro.