Comparing Carry Drivers of Futures Hedges and Asset Swaps

Summary

The document poses a comparison between two ways of hedging the financing and rate exposure of an investment-grade bond in an inverted curve environment. The investor buys a bond yielding less than three-month Euribor and wants to lock in a spread over financing costs. The alternatives are selling interest-rate futures strips corresponding roughly to the bond maturity, or entering an asset swap that receives floating Euribor and pays a fixed rate below the bond yield.

The question asks how returns differ after some time passes if market variables stay unchanged. It supplies the setup and relative yield conditions, including a negative TED spread for the futures approach, but gives no answer or worked comparison. The outcome would depend on details such as futures-strip repricing, bond carry and roll, swap cash flows, and hedge conventions, none of which are specified.

Key ideas

• The example compares futures-strip hedging with an asset swap for a financed bond investment.
• The bond yield is below the floating financing rate in the stated inverted-curve setup.
• The futures alternative is characterized by a negative TED spread, while the asset-swap fixed rate is below the bond yield.
• The text asks how elapsed-time returns differ with market variables held constant, but provides no resolution.

Tags

# Two types of hedge : impacts on position carry


# Two types of hedge : impacts on position carry












Think of an IG bond purchase, financed at 3M Euribor, in an inverted curve environment.

The yield on the bond, Y, is below the 3M Euribor, at purchase.

The investor is looking to lock in a spread over the financing cost over the whole period of the bond investment, and has two options:

- Sell interest futures strips, roughly corresponding to the maturity of the bond. The TED spread (Y - Implied Strips Bond yield) is negative.

or

- Enter into an asset-swap, where they receive floating 3M Euribor and pay a fixed rate F, where F < Y.

If we assume only passage of time, and no other market variables change, what are the differences in return drivers from 1) or 2) after a time interval t, where t < bond maturity T ?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.