Inter market trade: Rolling hedge

CFA Level III Derivatives
#1

Hi all,

In one CFAI topic test (last question Fixed income) it is mentioned that a rolling hedge will generate a profit if spread between two currencies increase. Why is that? Furthermore, they go on and mention that basically earnings from lending will increase compared to the cost of borrowing.

I have no clue on what they are talking about, perhaps someone can clarify this for me?

Regards

#2

The rolling hedge I think it is saying, the hedge expires and you have to “renew” the hedge. If the spread increases, you’re making money each time your roll the hedge.

#3

Would it be possible for you to help me out through an example? Still dont grasp it, sorry. Thx for helping me out

#4

I am not sure i my explanation can help you or not.

For example, you determine that you can implement inter-market carry trade by: Borrrow in curreny A to invest in currrency B and hedging by long the forward rare B/A. (1)

some months later, the i/r spread between country A and B widen (i/r B increase and i/r A decrease) => forward rate B/A will increase (2)

From (1) & (2), rolling hedge will generate positive return

#5

Lets say that I am a Swede who is interested in buying a bond in the US. The Rf in Sweden is 2%, the Rf in the US is 3%. So I long US and short Sweden…

I want to hedge out my currency risk.

Since my original transaction was going Long the USD, I needed to hedge my position by selling forward the USD for 12 months.

12 months later the spread has increased. Sweden has Rf of 1% and US of 4%. This will hopefully boost the carry trade l, moving forward, if yield curve assumed to stay as is.

But what do I gain on the hedge?

#6

But you are a swede…

#7

here is my understanding: rolling hedge is the way to hedge against the depreciation of foreign currency. as we know, R(DC)= (1+R(FC)) * (1+R(FX)) - 1.

say i am Canadian who has investment in CNY currency, where CNY/CAD is presently at 5. I would like to to see CNY strengthening over the period of investment, but will be upset to see otherwise. Therefore, i would like to lock my rate in CNY/CAD at 5 with a 3 month forward contract in day 1.

Right before the maturity of my contract, CNY/CAD increases to 6. in this case, i will unwind my previous unexpired contract at higher price and at the same time long another forward with 3 month