Hi CFA folks,
In curriculum volume 3 page 44 example 13: Bear Flattening Impact.
A fixed-income manager is considering a foreign currency fixed-income investment in a relatively high-yielding market, where she expects bear flattening to occur in the near future and her lower-yielding domestic yield curve to remain stable and upward-sloping. Under this scenario, which of the following strategies will generate the largest carry benefit if her interest rate view is realized?
a Receive-fixed in foreign currency, pay-fixed in domestic currency
b Receive-fixed in foreign currency, pay-floating in domestic currency
c Receive-floating in foreign currency, pay-floating in domestic currency
The answer is C. While I understand we would choose to receive floating since in the high-yield market, a bearish view (bear flattening) is expected, we want to reduce duration - receive-floating.
However, I am confused about why we want to pay-floating in domestic currency. The answer is “Given the upward-sloping domestic yield curve, we would expect the carry difference between receiving foreign currency floating rates and paying domestic currency floating rates to be the highest.”
Could someone help and tell me why the carry difference would be highest if choosing pay-floating domestically?
Many thanks.
Here are a few questions for you to answer:
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When you pay/receive fixed, are you paying/receiving a short-term rate or a long-term rate?
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When you pay/receive floating, are you paying/receiving a short-term rate or a long-term rate.
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Which is higher: the foreign fixed rate, or the foreign floating rate?
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Which is higher: the domestic fixed rate, or the domestic floating rate?
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In the near future, what will happen to the foreign floating rate?
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In the near future, what will happen to the foreign fixed rate?
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In the near future, what will happen to the domestic floating rate?
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In the near future, what will happen to the domestic fixed rate?
I see !
From answering your questions, I understand that the pay-floating rate is short term rate. As the local yield curve is stable and upward-sloping, the short-term rate is lower than long-term rate - so choosing to pay this floating rate is a better deal, is it correct?
Following my reply above, can I summarise as this:
When we say pay/receive floating - it refers to the short-term rate;
Pay/receive fixed - it more refers to long-term rate (although more precisely it’s decided between the parties)
Correct: it’s the short-term rate corresponding to the time between swap payments.
Correct: one based on the tenor (maturity) of the swap.
It’s not so much decided between the parties as it’s calculated between the parties: calculated to ensure that there’s no arbitrage opportunity for either party.
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