I’ve got difficulty understanding the solution to Qn 26 of the EOC, on why answer A is wrong.
The question is as follows:
Considering only the US, UK, and Euro markets, the most attractive duration neutral, currency- neutral carry trade could be implemented as:
A Buy 3- year UK Gilts, Sell 3- year German notes, and enter a 6- month FX forward contract to pay EUR/receive GBP.
B Receive fixed/pay floating on a 3- year GBP interest rate swap and receive floating/pay fixed on a 3- year EUR interest rate swap.
C Buy the T- note futures contract and sell the German note futures contract for delivery in six months.
The answer sheet in explaining why Answer A is incorrect:
A is incorrect. The FX forward position as stated (pay EUR/receive GBP) corresponds to implicitly borrowing EUR for six months and lending GBP for six months. Correct execution of the trade would require the opposite, receiving EUR and delivering GBP 6 months forward.
I need help in the way I should think about it.
Is this akin to “borrowing” in GBP to buy UK gilts by selling German EUR-denominated notes, and locking in the exchange rate in the forward market? This at the end of the term, he must pay GBP an receive EUR.
Somehow this does not intuitively register in my head. How does being in the FX forward market equate to borrowing and lending?