Ivankiv offers another recommendation: “Our analysts believe both Australian and British long-term yields will decline more than long-term German yields over the coming year, with Australian long-term yields falling the most by a wide margin. The British yield curve is more steeply sloped than the Australian. Rather than remain invested in bunds, Kuaminika could invest in either British gilts or Australian government bonds and hedge the currency risk back to the euro with a rolling three-month foreign currency forward. There are, however, some issues to keep in mind:
- Issue 1: The British gilt market is likely better for investment because its steeper yield curve provides larger benefits from ‘riding the curve.’
- Issue 2: In order to properly account for the cost/benefit of eliminating currency exposure, hedge gains or losses should be measured relative to forward foreign exchange rates.
- Issue 3: The rolling hedge will generate a profit (loss) if the spread between the short-term German yield and the short-term Australian or British yield increases (decreases) over time.”
Q. If all long-term rates fall as expected, which of Ivankiv’s issues regarding investment in the British gilt or Australian Treasury markets is least likely correct in the context of an inter-market trade?
- Issue 1
- Issue 2
- Issue 3
A is correct. Ivankiv is wrong regarding Issue 1. There is a stronger benefit from a larger relative decline in yields in the Australian market than the benefit from the steeper yield curve in the British market. Hedge gains and losses should be measured relative to forward rates, not anticipated spot rates. The rolling hedge is similar to borrowing short term in the Australian or British market and lending short term in the German market.
