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Lecture Multinational financial management - Topic 8: Carry trade and covered interest arbitrage

Lecture Multinational financial management - Topic 8: Carry trade and covered interest arbitrage. In this chapter, students can compute profits from carry trades and covered interest arbitrage, students understand the function and use of a credit default swap (CDS). | Topic #8: Carry Trade and Covered Interest arbitrage L. Gattis The Pennsylvania State University 1 Finance 407: Multinational Financial Management Review 2 The yen is selling at a 1% premium for one year delivery. U.S. Treasury yields are 3%. What is the Japanese sovereign yield according to IRP? A. 1.98% B. 3.98% C. 1.94% D. 4.04% E. 2.07% Learning Objectives 3 Learning Objectives Students can compute profits from Carry Trades and Covered Interest Arbitrage Students understand the function and use of a Credit Default Swap (CDS) The Yen Carry Trade 4 A “carry trade” in one in which you borrow a low interest rate currency and invest in a high interest rate currency. Throughout the 2000’s one of the most popular trades by hedge funds was the yen carry trade when Yen borrowing interest rates were less than 1% and U.S. Treasuries were near 3%. Example (assume spot price remains constant at ¥100/$) Borrow 1 million yen at 1% for one year Sell ¥1 million for $10,000 (¥1,000,000/(¥100/$)) . | Topic #8: Carry Trade and Covered Interest arbitrage L. Gattis The Pennsylvania State University 1 Finance 407: Multinational Financial Management Review 2 The yen is selling at a 1% premium for one year delivery. U.S. Treasury yields are 3%. What is the Japanese sovereign yield according to IRP? A. 1.98% B. 3.98% C. 1.94% D. 4.04% E. 2.07% Learning Objectives 3 Learning Objectives Students can compute profits from Carry Trades and Covered Interest Arbitrage Students understand the function and use of a Credit Default Swap (CDS) The Yen Carry Trade 4 A “carry trade” in one in which you borrow a low interest rate currency and invest in a high interest rate currency. Throughout the 2000’s one of the most popular trades by hedge funds was the yen carry trade when Yen borrowing interest rates were less than 1% and U.S. Treasuries were near 3%. Example (assume spot price remains constant at ¥100/$) Borrow 1 million yen at 1% for one year Sell ¥1 million for $10,000 (¥1,000,000/(¥100/$)) Invest $10,000 in 3% U.S. Treasury that returns $10,300 ($10,000*1.03) Repay Yen loan ¥1,010,000 (¥1,000,000*1.01) which costs $10,100 (¥1,010,000 /100) Earn $200 (10,300-10,100) or 2% (10,300-10,100)/10,000) profit. As long as exchange rates do not change when its time to payoff of the yen loan, you can borrow at 1% and invest at 3%. Effects Kept yen values low (hedge fund selling of yen, buying dollars) Created systematic risk to the appreciation of the yen (there was an estimated $1 trillion on the yen carry trade in 2007) What is the risk of this trade? The Yen Carry Trade: Example 2 5 According to IRP, the expected spot price of the yen in one year when U.S. and Japanese sovereign yields are 3% and 1%, respectively and the current spot price is ¥100 is S(1)=¥100*(1.01/1.03)=¥98.058 The USD Carry trade profit if the yen appreciates according to IRP is (Repaying ¥1M loan in dollars, converting yen to $ in spot and investing) Financing Costs = ¥1,000,000*1.01*$(1/98.058)/¥ =$10,300 .