I’m looking over carry trade implementation and I’m stuck on Sonia Alexis (BB type at bottom of page 139). They’re saying that you received fixed/pay floating in steeper marker and pay fixed/receive floating in the flatter marker to eliminate currency risk (top of page 139).
Halfway done on page 140, they say “in contrast, the NZD curve moves to relfect today’s implied forward rates the rate on the then 4.5 year swap will risk by 19 bps from 2.84 to 3.03, the resulting mark-to-market loss will exactly offset the carry accrual”
From exhibit 9, I can see tht the carry accrual is 122.5 bps. How does the 19 bps change result in offsetting this 122.5 bps? They give a footnote wit a duration of 4.2 and if you find the approximate price change using this we get:
delta price = 4.2 * .19 = 79.8 bps. This 79.8 bps is not offsetting the 122.5 bps though. Where’s the other 40 bps?
How does the resulting mark-to-market loss exactly offset the carry acrual then? From the passage it says:“the rate on the then 4.5 year swap will risk by 19 bps from 2.84% to 3.03%, the resulting mark-to-market loss will exactly offset the carry acrual”
Where are the numbers for this? I just want to understand where this offset is coming from? You mentioned that the 19 bps is from the 6-month NZD/5 year carry trade. Ok, but on the previous page, the accrual there is 44.5 bps for that pair. The 19 bps is not offsetting the 44.5. Again, i’m just confused and lost.
Have read lot of your posts and really like how you explain the questions.
For this one, tried to understand but not sure I got it right, can you help check my logic?
So , for 6-month NZD / 5-year NZD carry trade:
If the yield curve is stable, the total gain will be ~77.5bps, which equal to carry accrual 44.5bps plus the ride the yield curve capital gains 33bps (33bps derived from yield decreased from 2.92% to 2.76% )
If the yield curve reflect the implied forward rates (2.84% --> 3.03%, 19bps), the capital loss 79.8bps (= 19bps* Modified Duration 4.2 ~79.8bps) will more or less offset the gain 77.5bps, and the deal will be just breakeven.
Is this why the text book answer says " In contrast, if the NZD curve moves to reflect today’s implied forward rates, the rate on the then 4.5 year swap will rise by 19 bps from 2.84% to 3.03%, the resulting mark-to-market loss will exactly offset the carry accrual, and the Pay 6mo NZD/Receive 5yr NZD swap will just break even." ?
Recall from Level II fixed income: if the yield curve evolves according to the implied forward rates, then the holding period return will be the same no matter what maturity bond you hold; if you hold the investment for 6 months, you’ll earn today’s 6-month spot rate if you buy a 6-month bond, a 1-year bond, or a 20-year bond. Thus, if you’re long one bond and short another, your net yield will be zero.
