Can someone please explain why trading a positive roll yield is trading the forward rate bias? I understand the forward rate bias to be that a higher yielding currency appreciates rather than depreciates. So far so good. A positive roll yield is when (f1- f0)- (s1-s0) >0. I.e. the forward premiums are higher. What is the connection to this with interest rates? I am unable to reconcile these 2 concepts together.
The point is to keep the prospective of base currency.
Roll yield is kind of hedge cost and is typically negative. A negative roll yield indicates that the hedger was trading against the forward rate bias by buying a currency at forward premium or selling a currency at a forward discount. Otherwise, is the positive roll yield. The magnitude of the roll yield is given by |(F-S)/S| and the sign depends on whether the investor needs to buy or to sell the base currency forward.
When the hedge involves selling the low-yield currency and buying the high-yield currency in the P/B pair, then it connects to interest rate. For example, the currency P you want to hedge is the low-yielding currency. Then you should buy the currency B which is high-yielding currency. When you roll down this position the spot rate (S p/b) you received is higher than the forward rate (F p/b)you pay due to the forward rate bias. And there is a positive roll yield.
@Okachiang “When you roll down this position the spot rate (S p/b) you received is higher than the forward rate (F p/b)you pay due to the forward rate bias. And there is a positive roll yield.” Isn’t it the opposite? The forward rate should be higher than the spot rate?
You’re right, the forward rate should be higher than the spot rate. I made a mistake. And the what you should pay is spot rate (S p/b) and what you should receive is the forward rate (F p/b) when you hedge this forward position.
The process should be like this.
We have 2 currencies HYC and LYC
HYC = 10% rrates
LYC = 2% rates
Spot HYC/LYC = 100
Fwd HYC/LYC = 108 (I know not exactly right but kept the maths simple for my beneifit)
ABC is at a discount, XYZ at premium
We sssume UCIP does not hold. Spot will stay at 100.
Carry Trade
Borrow LYC Deposit HYC pick up 8% gain
LONG HYC Short LYC
Forwards
Negative roll yiield happens
Long LYC short HYC When it comes at expiry (spot not moved)
At expiry
Fwd Deliver 108 HYC Receive 1 LYC
Spot Sell 1 LYC Receive 100 HYC (or think need 1.08 LYC to cover 108 HYC)
= Loss of 8%
Positive roll yiield happens
Long HYC short LYC When it comes at expiry (spot not moved)
At expiry
Fwd Deliver 1 LYC Receive 108 HYC
Spot Sell 108 HYC Receive 108/100 = 1.08 LYC (or think need 100 HYC to cover 1 LYC)
= Gain of 8%
Carry trade = Long HYC
Fwd rate bias = Long HYC
+ve carry - LONG HYC
@Okachiang - thank you for your explanation. When ft> st there is a positive roll yield and when currency B appreciates rather than depreciates there is a forward trading bias.
I guess this is my confusion. You are describing this as 2 independent events. I read the text as simply saying that selling a forward premium and buying a forward discount is in itself violating uncovered interest rate parity. I was confused why this was.
Mikey, what if spot changes together with forward: you buy spot t=0 for 100 sell forward 108.
At t = 1 you have still gained 8 for the period (I.e. the same as if you did not enter the forward, just bought another currency and sold it later at a higher price) - what type of yield is that?
Is it not called Roll Yield?
Movement in spot prices = spot yield.
Return from is broken down into commodities
Price return/Spot yield = movement in underlying prices
Roll yield - as described - Think of this as your “base” case when assessing spot return (in reality it is done with difference in near and far futures as that is what people who roll commodity futures are doing). This could be a “tail wind” in that is working in your favour or a “head wind” working in your favour.
Collateral yield - return on any cash deposits assuming a fully cash back position.
As an example. Years ago, in my private investments, I decided I wanted to be long agricultural commodities. Asa small investor in UK when there were not such sophisticated markets there were few options - listed investments that addressed the theme indirectly : farm commodity brokers, companies with farm land, seed manufactures etc
I also picked a corn commodities fund. It was fiull cash backed so I invested whole value while the fund is invested in futures - so +ve colateral yield
I got the spot rate correct and corn prices rose. - yeah
But the corn markets was in backwardation and the rolling of futures contract wiped out most of my gains. My collateral was used up maintaining exposure to corn.
What I learnt was when commmodity markets are in backwardation. timing is important in your trades as the “head wind” is against you.
As more of a value stock investor I am used to dividends paying you an income while you “wait” for positive news. But in backwardation waiting can be expensive.