Inter market trade: Rolling hedge

Hi all,

In one CFAI topic test (last question Fixed income) it is mentioned that a rolling hedge will generate a profit if spread between two currencies increase. Why is that? Furthermore, they go on and mention that basically earnings from lending will increase compared to the cost of borrowing.

I have no clue on what they are talking about, perhaps someone can clarify this for me?

Regards

The rolling hedge I think it is saying, the hedge expires and you have to “renew” the hedge. If the spread increases, you’re making money each time your roll the hedge.

Would it be possible for you to help me out through an example? Still dont grasp it, sorry. Thx for helping me out

I am not sure i my explanation can help you or not.

For example, you determine that you can implement inter-market carry trade by: Borrrow in curreny A to invest in currrency B and hedging by long the forward rare B/A. (1)

some months later, the i/r spread between country A and B widen (i/r B increase and i/r A decrease) => forward rate B/A will increase (2)

From (1) & (2), rolling hedge will generate positive return

Lets say that I am a Swede who is interested in buying a bond in the US. The Rf in Sweden is 2%, the Rf in the US is 3%. So I long US and short Sweden…

I want to hedge out my currency risk.

Since my original transaction was going Long the USD, I needed to hedge my position by selling forward the USD for 12 months.

12 months later the spread has increased. Sweden has Rf of 1% and US of 4%. This will hopefully boost the carry trade l, moving forward, if yield curve assumed to stay as is.

But what do I gain on the hedge?

But you are a swede…

here is my understanding: rolling hedge is the way to hedge against the depreciation of foreign currency. as we know, R(DC)= (1+R(FC)) * (1+R(FX)) - 1.

say i am Canadian who has investment in CNY currency, where CNY/CAD is presently at 5. I would like to to see CNY strengthening over the period of investment, but will be upset to see otherwise. Therefore, i would like to lock my rate in CNY/CAD at 5 with a 3 month forward contract in day 1.

Right before the maturity of my contract, CNY/CAD increases to 6. in this case, i will unwind my previous unexpired contract at higher price and at the same time long another forward with 3 month