Carry trade at a macro hedge fund. Ms. Ivanhoe is the chief strategist of Caran dAchethe Fribourg-based

Question:

Carry trade at a macro hedge fund. Ms. Ivanhoe is the chief strategist of Caran d’Ache—the Fribourg-based (Switzerland) macro hedge fund. Newly issued oneyear Greek government zero-coupon (Z) bonds rekindled Ms. Ivanhoe’s interest in the carry trade.

a. What is the currency carry trade all about? Caran d’Ache can borrow 100 million Swiss francs (CHF) at an annual cost of 115 basis points and invest in Greek Z bonds currently trading at 89 and to be redeemed at par in 360 days. Zs are denominated in euros (€). The spot rate for euros is CHF 1. 25 = €1.

b. What are the risks involved in this carry trade? Under what exchange rate scenario(s) is the carry trade profitable?

c. Would you advise Ms. Ivanhoe to hedge her investments in Greek Z bonds?

Current one-year government bond yields are 95 basis points for AAA-rated one-year Swiss government bonds, 330 bp for AAA-rated German one-year government bonds, 360 bp for one-year AA-rated French government bonds, and 1,125 bp for BBB-rated Greek one-year government bonds. Illustrate graphically both hedged and unhedged investment policy. Discuss the significance of the intersection point.

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