4. Consider the following news from Reuters: 1407GMT [Dow Jones] LONDON—According to a large investment bank investors can boost yields using the following strategies: (1) In the strategy, sell 5-yr CDS on basket of Greece (9 bp), Italy (8.5 bp), Japan (4 bp), Poland (12 bp) and Hungary (16 bp), for 34 bp spread. Buy 5-yr protection on iTraxx Europe at 38 bp to hedge. Trade gives up 4 bp but will benefit if public debt outperforms credit. (2) To achieve neutral or positive carry, adjust notional amounts—for example in the first trade, up OECD basket’s notional by 20% for spread neutral position. (3) Emerging market basket was 65% correlated with iTraxx in 2005, hence use the latter as hedge.

(a) Explain the rationale in item (1). In particular, explain why the iTraxx Xover is used as a hedge.

(b) Explain how you would obtain positive carry in (2).

(c) What is the use of the information given in statement (3)?