Active Fixed-Income Management Across Currencies

$$ \textbf{Single asset}: R_{(dc)} = (1+ R_{fc}) \times (1+ R_{fx}) -1 $$

$$ \textbf{Portfolio}: R_{(dc)} = \sum \omega_i(1+ R_{fc}) \times (1+ R_{fx}) -1 $$

Where:

\(R_{dc}\) = Domestic currency returns (%).

\(R_{fc}\) = Foreign currency returns (%).

\(R_{fx}\) = Change of the domestic versus foreign currency (%).

\(\omega_i\) = Portfolio weight of each foreign currency asset (in domestic currency terms) with the sum of \(\omega i\) equal to 1.

Covered Interest Rate Parity

Covered interest rate parity is a no-arbitrage condition. It states that the difference between the forward and spot rates of two countries should equal the difference between their interest rates. This prevents investors from profiting by exchanging money in the forex market and investing in another currency. In essence, local currency interest rates should yield the same return as exchanging money, investing elsewhere, and converting it back. Another implication of covered interest rate parity is that:

• Countries with higher interest rates should trade at a forward discount.
• Countries with lower interest rates should trade at a forward premium.

Uncovered Interest Rate Parity

Uncovered interest rate parity suggests that hedging might not be worthwhile since currency investments without hedging can yield similar returns as those with hedging. While useful, it's crucial to note that this theory doesn't always hold in real-world scenarios. This is evident from the often superior returns achieved through carry trades, where investors borrow in lower-yielding currencies and invest in higher-yielding ones.

Carry Trade across Currencies

Executing carry trades across currencies involves borrowing one currency and utilizing the proceeds to invest in another with higher yields. For instance, a portfolio manager might borrow US dollars (perhaps at a 2% rate) and then use these funds to invest in Thai Baht (which offers a 7% rate). Typically, these trades prove lucrative in stable economic conditions, yet they can result in substantial losses during economic instability.

Consider a scenario where the current 1-year USD interest rate is 2%, and the 90-day Baht interest rate is 7% (annualized). As illustrated below, the manager’s strategy involves rolling over the 90-day Baht-denominated bonds upon maturity, leading to a potential profit.

$$ \left(1 + \frac {0.07}{4} \right)^4 – (1 + 0.02) \approx 5.185\%. $$

The risk to this trade would be the weakening the Thai Baht (the investment currency). Should the Baht weaken during the manager’s investment in its 90-day bonds, the trade could begin to lose significant money.

Cross-Currency Basis Swap

Cross-currency basis swaps are over-the-counter (OTC) derivatives where two parties exchange interest payments and principal in two different currencies. This entails swapping one currency’s interest payments and principal for the other currency’s principal and interest payments at fixed intervals throughout the agreement’s term. Cross-currency swaps are highly customizable and can involve various variable and fixed interest rate combinations.

These combinations include:

• Receive Fixed / Pay Fixed.
• Receive Fixed / Pay Floating.
• Receive Floating / Pay Fixed.
• Receive Floating / Pay Floating.

Question

Identify the most lucrative carry trade opportunity for a fixed-income portfolio manager who anticipates minimal changes in foreign currency movements as indicated in the table below:

$$ \begin{array}{c|c}
\textbf{Currency} & \textbf{Interest Rate} \\ \hline
\text{Great British Pound (GBP)} & 1.09\% \\ \hline
\text{Canadian Dollar (CAD)} & 1.02\% \\ \hline
\text{Zimbabwean Dollar (ZD)} & 9.62\% \\ \hline
\text{Swedish Krona (SK)} & 9.70\%
\end{array} $$

1. Borrow GBP and invest in ZD Bonds.
2. Borrow SK and invest in GBP Bonds.
3. Borrow in CAD and invest in SK Bonds.

Solution

The correct answer is B:

It recommends borrowing the Swedish Krona (SK) and investing in Great British Pound (GBP) bonds. The SK offers a higher interest rate (9.70%) than GBP (1.09%). This trade aims to profit from the interest rate differential but also carries currency risk, as the SK may fluctuate against the GBP.

A is incorrect. It suggests borrowing Great British Pounds (GBP) and investing in Zimbabwean Dollar (ZD) bonds. The GBP has a lower interest rate (1.09%) than the ZD (9.62%). This trade aims to profit from the interest rate differential (carry trade). However, it exposes the manager to potential currency risk, as the ZD may be unstable.

C is incorrect. It suggests borrowing Canadian Dollars (CAD) and investing in Swedish Krona (SK) bonds. CAD offers an interest rate of 1.02%, lower than SK’s rate (9.70%). Again, this trade aims to benefit from the interest rate differential while exposing the manager to potential currency risk, as the CAD may fluctuate relative to the SK.

Reading 21: Yield Curve Strategies

Los 21 (f) Discuss yield curve strategies across currencies