In reading 20 , 3.1.4 Carry Trade page 140-141 , there are three approaches provided to execute intra market( same currency) carry trade.
1 : Buy a bond and finance it in the repo market.
2 : Received fixed and pay floating on an interest rate swap.
3 : Take a long position in a bond future contract.
First two approaches are state-forward no issue but I am not to understand why third approach ( Long future contract ) is also equivalent to carry trade. Will someone please help me.
Hi @kacherasath:
Here’s how I understand it:
Remember, a carry trade is a form of leverage - that is, we find a way (through borrowing or derivatives) to enhance returns. Think about how a long position in a bond future works - if the yield curve is upward sloping, buying a 5-year bond future for delivery in 1-year will appreciate as the contract nears maturity, just like a bond (the rolldown). However, there won’t be a cash payment today. Instead, we will make the cash-for-bond transaction in 1-year. Therefore, we can take the money we have allocated to purchase the bond and invest it in a 1-year note that matures on the same date as we have committed to settling the futures contract. The return we will earn between the time we entered the contract and the time we settle it will be equal to the bond’s capital appreciation (rolldown) and coupon interest (bound by arbitrage) plus the interest we earn on investing the cash we could have used to purchase the bond (could be borrowed money). So if you compare the 2 options (1) buying the bond outright versus (2) buying the futures contract, your return should be higher with the futures contract due to the interest rate received on the idle cash. See below:
Option 1: Buy the bond outright, receive coupon interest + capital appreciation
Option 2: Enter the 1-year futures contracts, receive future contract capital appreciation (equal to the bond rolldown coupon interest, which we assume is bound by arbitrage) + interest on the cash invested in a 1-year note. Cash for bond transaction happens at the end of 1-year.
Hopefully, this helps!