Tài chính doanh nghiệp - Finance 407: Multinational financial management - Topic 8: Carry trade and covered interest arbitrage

Topic #8: Carry Trade and Covered Interest arbitrageL. GattisThe Pennsylvania State University1Finance 407: Multinational Financial ManagementReview2The 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 Objectives3Learning ObjectivesStudents can compute profits from Carry Trades and Covered Interest ArbitrageStudents understand the function and use of a Credit Default Swap (CDS)The Yen Carry Trade4 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 yearSell ¥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%. EffectsKept 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 25According 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)=¥98.058The 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)/¥ =$10,300Proceeds = ¥1,000,000*(1/100)*1.03=$10,300Profit = $10,300 - $10,300 = 0Carry trade profits are zero if the future spot price is the IRP theoretical value. Alternative arbitrage free argument for IRPCarry Trade6A successful carry trade strategy is to borrowing a low interest rate currency which has structural impediments that prevent the appreciation of the currency and invest in a higher yield investment.The loan proceeds are not just invested in AAA-rated, sovereign, fixed income bonds. Funds are also invested intoEmerging Market Sovereign DebtU.S., E.A.F.A., and E.M. StocksReal EstateIn this case, the investor is subject to the risk that the borrowed currency appreciates and the investment declines in value.The Yen Carry Trade: Example 3 (Hedged)7U.S. and Japanese yields are 3% and 1%, respectively. The current spot price is ¥100 and the one year forward rate is ¥99.00. What are the profits from borrowing ¥1M yen, selling yen to buy USD, investing in U.S. Treasuries, and entering into a forward contract to repay the yen loan?-$198-$980$98$198Covered Interest Arbitrage: Using a forward contract to lock into the future spot rate on a carry tradeCovered Interest Arbitrage8CIA is the borrowing of one currency and investing in another currencyThere are two ways to earn USD profits Borrow domestic currency (DC), Invest in the Foreign currency (FC) bondBorrow foreign currency (FC), Invest in domestic currency (HC) bondBorrow Domestic CurrencyBorrow DCSell DC/Buy FC in Spot Market Invest FC in Foreign BondSell FC/Buy DC in Forward Market (FC Amount is Foreign Bond Maturity Value)Borrow Foreign CurrencyBorrow FCSell FC/Buy DC in Spot Market Invest DC in Domestic BondSell DC/Buy FC in Forward Market (FC Amount is FC Loan Payoff)CIA: Borrowing Domestic9The Pakistan rupee (PKR) is selling for PKR86.01 per USD and 1-year forward points were +200. The US 1-Yr rates are 4.9875% and PKR rates are 9.44%. What are the USD profits from borrowing $1,000, buying rupee at the spot, investing in PKR government bonds, and selling the 1-year PKR bond proceeds at the forward rate?-$19.66$-9.66$0$9.66$19.66CIA and IRP10Interest Rate Parity (IRP) states that forward premiums are related to relative interest ratesRearranging termsThe LHS of the above equation is the domestic interest rate + 1The RHS of the above equation is the domestic interest rate of a hedged foreign investment (or loan) + 1Loan E.g.; Pay foreign rate plus the appreciation of the FCCIA profits exist if this equality is notCovered Interest Arbitrage (CIA)11William Wong, arbitrager for Hong Kong Banking Corp. sees the following currency quotations:e0 = ¥106.00/$ 6 mo yen rate = 4% APR (2% 6mo)F0,180 = ¥103.50/$ 6 mo dollar rate = 8% APR (4% 6mo)William checks the IRP relationship: 1.04 < (1.024155)(1.02) 1.04 < 1.045The Hedged Yen interest rate is actually higher than the USD Rate --- So, Borrow at “low rate” (USD) and invest in “high rate” (YEN)USD RateHedged Yen Interest Rate (USD Return)FP =(106-103.5) / 103.5 = .024155Covered Interest Arbitrage (CIA)12Thus, William will perform an arbitrage in which he borrows $, buys yen in the spot market, invests the yen, and then sells the yen forward.¥106,000,000for six monthsat r$ = 8%(4% for 6 mos)¥108,120,000Borrow$1,000,0001ConvertSpot at 106 ¥/$2Repay LoanInvest for six monthsat r¥ = 4%(2% for 6 mos)3Cover Forward at 103.5 ¥/$4Profit = $4,638¥108,120,000-$1,040,000$1,044,638¥106,000,0004Covered Interest Arbitrage (CIA)13Covered interest arbitrage should continue until interest rate parity is reestablished, because the arbitrageurs are able to earn risk-free profits by repeating the cycle. But their actions nudge the foreign exchange and money markets back toward equilibrium: Purchase of yen in the spot market and sale of yen in the forward market narrow the premium on the forward yen. The demand for yen-denominated bonds causes yen interest rates to fall, while the higher level of borrowing in the U.S. causes dollar interest rates to rise. Covered Interest Arbitrage14We now know how to find a CIA in the simple case of no transaction costs. But what if spot and forward exchange rates and interest rates are in bid/ask quotes and there are borrowing and investing interest rates?We know the arbitrage will involve borrowing either foreign currency (FC) or domestic currency (DC). So we look for one of the following two possible arbitrages:Borrow DC at Borrowing RateSell DC/Buy FC @ Bid or Ask Depending on Direct/IndirectInvest FC in Foreign Risk-Free Investing RateSell FC/Buy DC in Forward Market @ Bid or Ask Depending on Direct/IndirectBorrow FC at Borrowing RateSell FC/Buy DC @ Bid or Ask Depending on Direct/IndirectInvest DC in Domestic Risk-Free Investing RateSell DC/Buy FC in Forward Market @ Bid or Ask Depending on Direct/IndirectCIA with Transaction CostsOn checking Bloomberg, you see the following exchange and interest rate quotes:151. Loan Repayment Cost: -$1,000,000*(1+.0503/4)=-$1,012,5752. Investment Proceeds: a. How many CHF can you buy and invest? $1,000,000/.8144=Sf1,227,898 b. How many CHF will you have at the end of the investment? Sf1,227,898(1+.0314/4)=Sf1,237,537 c. How many USD can you get in exchange for the CHF investment proceeds using a forward contract? Sf1,237,537*.8226=$1,017,9983. What are your USD profits? $1,017,998-$1,012,575 = $5,423What is your profit if you borrow $1M, buy francs and invest them, and sell the expected franc investment proceeds forward to payoff the dollar loan? What’s the risk?15Currency3-month Sovereign Yields(ann)3-monthLIBOR Yields (ann)Spot (direct quote)3-month ForwardUSD4.99%5.03%CHF3.14%3.19%$0.8132 - 44$0.8226 - 32Credit Default Swap (CDS)16A CDS contract makes a payment to the buyer of the CDS if a specified bond defaults. The buyer pays periodic premiums – like insuranceCDS contracts can be used to guarantee the payment of a corporate or government bondCost is paid over the life of the bondE.g., pay 50 bps of par at each annual coupon payment date to guarantee payment of contractual interest and parCIA with CDS is a true risk-free investmentE.g., If investing in Thai government bond as a part of a CIA on the Thai Baht, subtract the 50bps (CDS quoted price) from the investing rate to compute the risk-free rate of returnCDS contracts have bid-ask spreads quoted in bps. E.g., 1-year Thai Sovereign CDS may be quoted at 40-50: The cost is 50 bps per year to buy the contract (insurance) and you would receive 40 bps if you sell (write) the CDS. If you write the CDS, you are obligated to make payment in the case of default.CIA with CDS Example17The Pakistan rupee (PKR) is selling for PKR86.01-86.02 per USD and 1-year forward points are +200/+210. The US 1-Yr LIBOR is 4.9875% and PKR government yield is 9.44%. What are the CIA USD profits from borrowing $1,000 and investing in PKR governments? (NO CDS)$18.32 $18.44$19.53$41.73$44.13Pakistan government bond CDS points were 218-257 (bid-ask basis points). What are the CIA profits if the CDS is purchased to insure against a PKR bond defaults?-$6.76 $0$6.76Problems18What are your USD profits in the following Swiss carry trade. You borrow 100,000 Swissie for 0ne-year at 3% and invest in U.S. Treasuries that yield 4.5%. The swissie spot is $1.1020-$1.1029 (Bid-ask). At the maturity the swissie is selling at $1.1143 - $1.1154.Loan Cost in USD = -Sf100,000*1.03*1.1154Investment Proceeds in USD = Sf100,000*1.1020*1.045 Carry Profit = Sf100,000*1.1020*1.045-Sf100,000*1.03*1.1154=$273What are your profits from the previous problem if the swissie is selling for $1.2008 - $1.2039 at maturity?Sf100,000*1.1020*1.045-Sf100,000*1.03*1.2039=-$8,843 Loss because Swiss appreciated before loan payoff – costing more USD to payoff loanSuppose the Yen/$ spot rate is 120 and the 1-year forward rate is 115. Interest rates in Japan and U.S. are 2% and 4%, respectively. Describe how you could exploit this arbitrage opportunity. (Select one and explain using the IRP formula)a. Borrow dollars, sell yen at the spot, invest in Japan, buy yen forwardb. Borrow yen, sell yen at the spot, invest in U.S, buy yen forward, c. Borrow dollars, buy yen at the spot, invest in Japan, sell yen forward,d. Borrow yen, buy yen at the spot, invest in U.S., sell yen forward,C. IRP: (1+Yen Premium) = (1+r$)/(1+rY); (1+r$)=(1+r¥)(1+Premium¥) (1+r$)=?(1+r¥)(1+Premium¥) .. Yen Forward Premium = (120-115)/115 = 4.34%1.04<(1.02)(1.0434)LHS ($ Rate) is low, so borrow USD, borrow cheap USD, buy yen, invest yen, sell yen forwardProblems19Suppose interest rates in the U.S. and Switzerland are 10% and 6%. The Swiss franc spot rate is $.7333 and 1-yr forward exchange rate is $.7555. What are the covered interest arbitrage USD profits from borrowing 1,000 francs, buying dollars at the spot, investing the dollar in the U.S. for one year, and repaying the franc loan with a forward contract? CIA Loan Cost in USD =-Sf1,000*1.06*.7555 CIA Investment Proceeds in USD = Sf1,000*.7333*1.1 CIA USD Profit =-Sf1,000*1.06*.7555 + Sf1,000*.7333*1.1=$5.8Suppose 3-month U.S. investing and borrowing rates are 4% and 8% APR and Aussie rates are 6% and 9%. The Aussie is selling for $1.2077- $1.2133 (bid-ask) in the spot market. The 3-month forward rate is selling at a $1.1522-$1.1544. What are your CIA USD profits from borrowing 100,000 USD and investing in Australia? CIA Loan Cost in USD = -$100,000*1+(.08/4) CIA Investment Proceeds in USD = $100,000/1.2133*(1+.06/4)*1.1522 CIA USD Profit = -$100,000*1.02 + $100,000/1.2133*1.015*1.1522 = -$5,611What are your CIA USD profits from borrowing 100,000 aussies (investing in U.S.)? CIA Loan Cost in USD = -A$100,000*(1+.09/4)*1.1544 CIA Investment Proceeds in USD = A$100,000*1.2077*(1.01) CIA USD Profit = -A$100,000*(1+.09/4)*1.1544+A$100,000*1.2077*(1.01)=$3,940Problems20Suppose the spot Mexican peso is P12.5 – P12.6 and one year forward market is 12.8-12.9. Mexican investing and borrowing interest rates are 8-10%. U.S. investing and borrowing interest rates are 1-3%. The Mexican CDS market rate is 150bps-175bps. What are your USD CIA profits without a CDS borrowing $100,000 in the U.S. and investing pesos? What is your profit with a CDS?CIA= -100000*1.03+100000*12.5*1.08/12.9=$1,651CIA+CDS= -100000*1.03+100000*12.5*(1.08-.0175)/12.9=-$45Textbook21Shapiro and Sarin’s Foundation of Multinational Finance 6th Ed. Chapter 4 covers currency forecasting and covered interest arbitrageiClicker: Class Evaluation22How would you rate today’s class? Highest Lowest