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Explain how yield curve positions are taken across more than one currency

CFA® Level III · Portfolio Management Pathway · Yield Curve Strategies · L3.PM.5.f

The idea

Yield curves in different countries reflect each economy's monetary policy, inflation and growth, so a manager may overweight the market where yields are expected to fall most or trade relative slope. In base-currency terms, return is roughly the local bond return plus the currency return. If the currency is hedged with forwards, covered interest parity means the hedged return is roughly the local return plus the short-term rate differential (domestic rate − foreign rate), so hedging gives up much of a high-yield market's extra yield. Carry trades that borrow in low-rate currencies and invest unhedged in high-rate ones are a bet that uncovered interest parity fails. The trap is comparing unhedged yields across markets as if currency were irrelevant.

Formulas

Return on a currency-hedged foreign bond

hedged return ≈ local return + (domestic rate − foreign rate)

hedged return
the return in the base currency with the currency hedged by forwards
local return
the bond's return in its own currency
domestic rate
the base currency's short-term rate
foreign rate
the bond currency's short-term rate

Covered interest parity makes hedging a high-yielding market give up much of its extra yield, so compare hedged returns, not raw yields, across markets. Unhedged, the return is roughly the local return plus the currency's move.

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