Hi Forum, long time no see.
Example:
|6 month LIBOR|1 year| 3 year|5 year|
|U.S. (USD) | 1.20%|1.40%|1.50%|1.50%|
|U.K. (GBP) |1.40%|1.80%|2.00%|2.10%|
|Germany (EUR)|–0.4%|0%|0.1%|0.2%|
US: flattest curve (smallest difference between the shortest and longest maturities)
UK: steepest curve (largest difference between the shortest and longest maturities)
So, you go: long GBP 5y, short GBP 6M
long USD 6M, short USD 5y
+2.1 + 1.2% –1.4 – 1.5 = 0.4%
However, in the following example (Volume 4 of the curriculum, page 224):
Floating Fixed Rate with Semi- annual Payments
6 Mo 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr
Euro 0.15% 0.25% 0.30% 0.40% 0.50% 0.60%
UK 0.50% 0.70% 0.80% 0.95% 1.00% 1.10%
US 1.40% 1.55% 1.70% 1.80% 1.90% 1.95%
And the solution says:
In order to be duration- neutral and currency- neutral, the trade must lend long/borrow short in one market and do the opposite (lend short/ borrow long), with the same maturities, in another market. The best carry is obtained by lending long/borrowing short on the steepest curve and lending short/borrowing long on the flattest curve. The GBP curve is the steepest and the EUR curve is the flattest. The largest yield spread between these markets is 0.55% at the 3- year maturity, and the narrowest spread is 0.35% at the 6- month maturity. Hence, the best trade is to go long the GBP 3- year/short the EUR 3- year and long the EUR 6- month/short the GBP 6- month. This can be implemented in the swaps market by receiving 3- year fixed/paying 6- month floating in GBP and doing the opposite in EUR (receiving 6- month floating/paying 3- year fixed). The net carry is +0.10% = [(0.95% – 0.50%) + (0.15% – 0.40%)]/2 for six months.
My question is: why don’t we apply the same logic as in example 1?
If we take the shortest and longest maturities (6M, 5Y), we get the Euro as the steepest, and the GBP as the flattest…
Why do we take the longest maturity as being 3y?
They orientate themselves according to the largest differences in yields across all maturities, between Euro and GBP. Then why not take the yield difference between the US and the EUR or between US and GBP - it is larger than between EUR and GBP, for instance.
Is there smth wrong with this book example?
Thanks a lot!