I cant seem wrap my head around this currency neutral inter-market carry trade concept. One of the strategies is “long position in 10-year bund futures and a short position in 10-year Treasury futures.” How does this strategy avoid currency risk when you long in EUR and short in USD?
Another unrelated question, carry trade method - to borrow in a lower interest rate and invest in a higher interest rate currency. “The currency risk in such carry trades cannot be hedged because interest rate parity dictates that the currency with the higher yield will trade at a forward discount to the lower yield currency. If the currency were hedged, it would offset the short-term interest rate differential in the two countries.” I don’t understand why it cant be hedged?
What about the 1st question? How does long in EUR bund futures and short in USD treasury futures avoid currency risk?
i understand why the swaps would not have currency risk since it buys & sells in one currency and buys & sells in another currency.
But for the futures, I just don’t understand how the currency risk is canceled out.
It’s from the online topical qns:
B is correct. 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).
"Standard arbitrage arguments imply that the futures contract price should equal the cost of buying the bond today and financing it to the futures delivery date less the yield earned before delivery. If the futures price were higher the seller of the futures contract could make an arbitrage profit by explicitly buying and financing the bond and then delivering the bond against the futures contract. If the futures price were lower the buyer of the futures contract could make an arbitrage profit by selling the bond short today, investing the proceeds in the money market, and taking delivery of the bond via the futures contract.8 With arbitrage enforcing this relationship between spot and futures prices, the futures price will converge to the spot price at expiration, and the long futures position will have implicitly earned the accrued interest on the bond and paid the financing cost.
…In order to eliminate currency exposure in an inter-market trade, the investor must, explicitly or implicitly, both borrow and lend in each currency. The essence of this trade is to exploit differences in the slopes of the two yield curves rather than the difference in overall rate levels. The idea, assuming normal, upward sloping yield curves, is to lend at the long end and borrow at the short end on the relatively steep curve, and to lend at the short end and borrow at the long end on the relatively flat curve. Among the ways to implement this trade are the following:
Receive fixed/pay floating in the steeper market and pay fixed/receive floating in the flatter market.
Take a long position in bond (or note) futures in the steeper market and a short futures position in the flatter market."
Which is why you do two trades: in one you’re long EUR futures and short USD futures (of the same maturity as each other); in the other, you’re long USD futures and short EUR futures (of the same maturity as each other, in the same amounts as those of the first trade, but a different maturity than that of the first trade).