Simply by just memorization I understand that a carry trade is valuable only if stable and upward sloping curves. There was another post related to problem 7 in section 24 as to why the carry trade is not valuable when long rates rise and short rates rise. S2000 said why borrow at 2 and invest at 5 when you can at 1 and 7 later.
With exhibit 8 and 9 on page 139 the carry trade is also discussed with GBP and MXN currency. THey mention that the intermarket trade is valuable if she has confidence that the MXN rates will not rise (yield is flat for MXN) and flat for GBP. Here what is this rate referring to? Short end or long end? And what if the MXN rate falls? This makes it seem as if it is valuable still if it falls.
Is a carry trade only valuable if stable? Or can it be valuable if rates drop?
You wrote this in the other post. Bear with me, FI is not my thing. This is related to my question above.
“If you borrow at 1% (short term rates) and then invest at 6% (long term rates)…. and then the yield curve steepens, which raises the rates to 15%… (exaggerated example of an EM). You try to close out your carry carry trade… what happens to the value?”
This is related to my question above where I wrote “THey mention that the intermarket trade is valuable if she has confidence that the MXN rates will not rise (yield is flat for MXN) and flat for GBP. Here what is this rate referring to?”
Part 1 of my question. You mention the 15%. How does that relate to the 1% and 6%. Do they both rise? I understand the overall idea that we’re in a leveraged position and worse overall. Does this mean we’re now borrowing at 15% and investing at 6%? I’m confused about the rate. Above
Part 2 of my question. “And what if the MXN rate falls? This makes it seem as if it is valuable still if it falls.”
Above we discussed steeping or rate rising but what happens if instead of rates rising to 15% (as you said), they drop to a .25. Are we then borrowing at .25% and investing at 6% in your example and better off? Very confused about how rate increase/decrease affects the short and long end.
The 15% refers to the long rate. If a yield steepens, the long rate (6%) increases – here, we said it would increase to 15%… that causes the value of your bond to decrease substantially.
This just says when you convert back to your currency, your carry trade won’t be a loser because of the currency exchange back into your base currency. If currency doesnt change, your carry trade profits from the difference in interest rates (the rate your borrowed versus the rate you invested). If the currency rates change, then it depends if your base currency appreciated or depreciated. If your base currency appreciated, converting back to it loses money, and you could end up losing more than your gains. The direction of the currency depends on if you borrowed on the foreign or if you’re investing in the foreign, or both.
Thanks a bunch. So that cleared that up very well. Thanks again.
But what about part 2 of my question: If rates fall
If rates fall, and the long rate is now .25% and the curve flattens, this would cause the value of my bond to increase significantly. So in this case, why am I not in better shape?
Again, thanks a lot. Mind is tired!