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TRABALHO DE CONCLUSO DE CURSO TCC

Analysis of Profitability and Optimal Terms of Operation

So Paulo - SP

2017

II

Analysis of Profitability and Optimal Terms of Operation

Rogrio Mori

(Coordenador Acadmico)

Guido Chagas

(Professor Orientador)

CEBANKING de Ps-Graduao Lato Sensu, Nvel de Especializao

da Escola de Economia de So Paulo/FGV/EESP para obteno do

ttulo de Especialista.

SO PAULO - SP

2017

III

Analysis of Profitability and Optimal Terms of Operation

Acadmica foi aceito como pr-requisito para a obteno do Nvel de

Especializao do Curso de Ps-Graduao, lato-sensu, Nvel de

Especializao, da Escola de Economia de So Paulo/FGV/EESP

Rogrio Mori

Coordenador Acadmico

Guido Chagas

Professor Orientador

IV

TERMO DE COMPROMISSO

CEBANKING, da Escola de Economia de So Paulo FGV/EESP, realizado nas

dependncias desta instituio, localizada em So Paulo, no perodo de Fevereiro

de 2016 a Agosto de 2017 declara que o contedo do TCC TRABALHO DE

CONCLUSO DE CURSO intitulado "Currency Carry Trade: a Quantitative Analysis

of Profitability and Optimal Terms of Operation", autntico, original, e de sua

autoria exclusiva.

_______________________________

V

ABSTRACT

In this paper, we study the effectiveness of carry trade operations having the

Brazilian Real as the destination currency, analyzing different operating strategies

including different ways of using treasury securities to settle the operation, different

time frames (1 month, 3 months and 1 year) and three currency pairs (USD/BRL,

MXN/BRL and CNY/BRL). Our results suggest that longer time frames, i.e., 1 year,

produce superior results and the best currency pair to operate with is the Mexican

Pesos / Brazilian Reais. In addition, when using Brazilian fixed-rate treasury

securities to operate in this market, the best strategy is carrying the paper until its

maturity, regardless of the remaining time until maturity.

The use of foreign exchange hedge and interest rate hedge was also analyzed,

aiming to evaluate the efficiency of Brazil's Future market. The levels of profitability

achieved in the simulations when hedge is used signals that arbitrage opportunities

are available and this market is not efficient in Brazil.

Key words: carry trade, time frame, currency pair, foreign exchange hedge, interest

rate hedge, treasury securities.

VI

List of Tables

Table 1: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Table 2: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Table 3: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Table 4: Average annualized break-even-rates obtained with Mexican Pesos (funding currency) and

Table 5: Average annualized break-even-rates obtained with Mexican Pesos (funding currency) and

Table 6: Average annualized break-even-rates obtained with Chinese Yuan (funding currency) and

Table 7: Average annualized break-even-rates obtained with Chinese Yuan (funding currency) and

Table 8: Annualized break-even-rates obtained with USD, MXN and CNY as funding currencies and

Table 9: Average annualized break-even-rates obtained with USD, MXN and CNY as funding

currencies and Brazilian Reais as destination currency from 2012 to 2017. ____________________ 30

Table 10: Average annualized break-even-rates obtained with US Dollar, Mexican Peso and Chinese

Yuan as funding currencies and Brazilian Reais as destination currency from 2004 to 2017, using the

Pr x DI curve. ___________________________________________________________________ 31

Table 11: Average annualized break-even-rates obtained with US Dollar, Mexican Peso and Chinese

Yuan as funding currencies and Brazilian Reais as destination currency from 2012 to 2017, using the

Pr x DI curve. ___________________________________________________________________ 32

Table 12: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Brazilian Reais (destination currency) from 2004 to 2017, using the Dollar x Real curve for hedge. _ 34

VII

Table 13: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Brazilian Reais (destination currency) from 2012 to 2017, using the Dollar x Real curve for hedge. _ 35

Table 14: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Brazilian Reais (destination currency) from 2004 to 2017, using the Dollar x Real curve for hedge. _ 36

Table 15: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Brazilian Reais (destination currency) from 2012 to 2017, using the Dollar x Real curve for hedge. _ 36

Table 16: Average volatility for the USD/BRL currency pair considering different time intervals (1

Table 17: Comparison between average annualized break-even-rates obtained with US Dollars as the

Table 18: Comparison between average annualized break-even-rates obtained with Mexican Pesos

Table 19: Comparison between average annualized break-even-rates obtained with Chinese Yuans

Table 20: Break even rates volatility with and without the use of FOREX hedge for the USD/BRL

currency pair, using Methodology 1 for the calculation of yield rates. _________________________ 43

Table 21: Break even rates volatility with and without the use of FOREX hedge for the USD/BRL

currency pair, using Methodology 2 for the calculation of yield rates. _________________________ 43

Table 22: Yield rates comparison for the break even rates obtained using Methodology 1 for the

Table 23: Yield rates comparison for the break even rates obtained using Methodology 2 for the

Table 24: Risk-Reward ratios for the break even rates obtained using Methodology 1 for the USD/BRL

Table 25: Risk-Reward ratio for the break even rates obtained using Methodology 2 for the USD/BRL

Table 26: Average annualized break-even-rates for the USD/BL currency pair, with and without

currency hedge, using the Dollar x Real curve for hedge. __________________________________ 46

Table 27: Average annualized interest rates for the United States of America in different time periods

VIII

List of Figures

IX

Summary

INTRODUCTION ................................................................................................................... 1

1. PROJECT OVERVIEW................................................................................................... 3

1.1 Aims and Objectives ................................................................................................ 3

1.2 Project Motivation .................................................................................................... 3

1.3 Literature Review ..................................................................................................... 4

2. THEORETICAL REVIEW ............................................................................................... 6

2.1 Carry Trade Examples ............................................................................................. 6

2.2 CIP and UIP............................................................................................................. 7

2.3 Treasury Securities - Prices and Rates .................................................................... 8

2.3.1 NTN-F............................................................................................................... 8

2.3.2 NTN-B .............................................................................................................. 9

2.3.3 NTN-B Principal .............................................................................................. 10

2.3.4 LFT ................................................................................................................. 11

2.3.5 LTN ................................................................................................................ 12

2.4 Flat-Forward Interpolation ...................................................................................... 14

2.5 Linear Interpolation ................................................................................................ 16

2.6 Fixed Rate Yield Curve .......................................................................................... 17

2.7 DOLLAR vs. REAL Curve ...................................................................................... 18

2.8 Foreign Exchange Coupon .................................................................................... 18

2.9 Carry-to-Risk Ratio ................................................................................................ 20

3. DATA AND RESOURCES ........................................................................................... 21

3.1 Software ................................................................................................................ 21

3.2 Foreign Exchange Historical Rates ........................................................................ 21

3.3 Treasury Securities Historical Unitary Prices ......................................................... 22

3.4 Fixed Rate Yield Curve .......................................................................................... 22

3.5 DOLLAR vs. REAL Curve ...................................................................................... 23

3.6 Exchange Coupon Curve ....................................................................................... 23

3.7 United States, Mexico and China Historical Yield Rates ........................................ 23

4. METHODOLOGY AND RESULTS ............................................................................... 24

4.1 Analysis 1 - Use of Real Assets and 3 Different Time Frames ............................... 26

4.1.1 Methodology - Analysis 1 ................................................................................ 26

X

4.2 Analysis 2 - Carrying the Assets Until Maturity....................................................... 29

4.2.1 Methodology - Analysis 2 ................................................................................ 29

4.2.2 Results - Analysis 2 ........................................................................................ 30

4.3 Analysis 3 - Real Assets vs. Yield Curve ............................................................... 31

4.3.1 Methodology - Analysis 3 ............................................................................... 31

4.3.2 Results - Analysis 3 ........................................................................................ 31

4.4 Analysis 4 - Hedging Foreign Exchange Exposure ................................................ 32

4.4.1 Methodology - Analysis 4 ................................................................................ 32

4.4.2 Results - Analysis 4 ........................................................................................ 34

4.5 Analysis 5 - Hedging Both Foreign Exchange and Interest Rate Exposure ............ 35

4.5.1 Methodology - Analysis 5 ............................................................................... 35

4.5.2 Results - Analysis 5 ........................................................................................ 36

5. RESULT ANALYSIS AND COMPARISONS ................................................................ 37

5.1 Analysis 1 .............................................................................................................. 37

5.2 Analysis 2 .............................................................................................................. 39

5.3 Analysis 3 .............................................................................................................. 39

5.4 Analysis 4 .............................................................................................................. 42

5.5 Analysis 5 .............................................................................................................. 46

CONCLUSION..................................................................................................................... 48

REFERENCES .................................................................................................................... 50

XI

1

INTRODUCTION

with a relatively low interest rate and uses the funds to invest in a different currency

yielding a higher interest rate. A trader using this strategy attempts to capture the

difference between the rates, which can often be substantial, depending on the

amount of leverage used.

The carry trade label has also been used more broadly to refer to investment

strategies designed to profit from almost any type of expected return differential, such

as borrowing and investing in risky assets of the same currency, or simply investing

in rapidly appreciating commodities. However, in this project, the term is used to refer

mainly to the strategy described in the paragraph above.

The mechanics behind this type of operation is very simple and, disregarding

externalities like transaction costs, a trader stands to make a profit of the difference in

the interest rates of the two countries as long as the exchange rate between the

currencies does not change. Changes in the exchange rate can either enhance or

diminish the profits depending on their directions.

Magazine, the emerging markets carry trade is estimated to be at least $2 trillion in

size. Other researchers conducted by the Bank for International Settlements (2015)

and the World Bank (2015) estimate the size of the US Dollar carry trade to be at

least $1 trillion. There are some estimates that it could be as high as $3 trillion. To

put these numbers in perspective, the size of the 2015 Brazilian GDP was around

$1.8 billion in the same year.

As mentioned in Santaella et. al. (2015), capital inflows (and reversals) pose a

number of challenges for monetary authorities. Among the various types of capital

flow, currency carry trades raise particular concerns because they may be de-

stabilizing: they may contribute to extended periods of currency appreciation, moving

and keeping the real exchange rate away from its fundamental equilibrium. In

addition, because they are funded mostly by debt, with high levels of leverage, they

may also be associated with currency crash risks.

2

Although Carry Trades may seem very simple to understand and operate, this types

of trade can bring serious consequences to a country's economy, especially when

talking about emerging markets economies. It does not take much to understand that

when one of the carry trade pillars begins to crumble (currency exchange rates), the

entire trade must be unwound, and since this is an extremely crowded market, the

unwind can be disorderly. As the trades starts to unwind, it becomes a self-fulfilling

process, with the outflow of invested money from emerging market economies

resulting in a weaker economic growth and weaker currency, which, in turn, causes

more unwinding and on and on it goes.

This project aims to identify whether it is worthy taking the risk and operating in this

market, i.e., what does historical data tell us about the profitability of this type of

operations considering the presence of market frictions that are usually taken for

granted in studies conducted in this field, different time horizons and different

currency pairs.

Also, can carry trade operations be hedged somehow in order to decrease the risks

Inherent to the pillars involved in this trade? An analysis of the Forwards and Futures

market will be conducted in the context of this project in order to answer this

question.

3

1. PROJECT OVERVIEW

The central aim of this project is to evaluate the profitability of carry trade operations

starting from the analysis of historical data and considering a full picture of how they

would happen in the real world. Departing from this central aim, the objectives can be

defined as:

interest rate differentials adjusted for exchange rate volatility (as measured by the

carry-to-risk ratio).

Historical profitability considering different currency pairs: USD/BRL, MXN/BRL

and CNY/BRL.

Profitability for different time horizons.

The effect of market frictions, considering Brazil as environment.

An analysis of carry trades in the context of the Uncovered Interest Rate Parity

(UIP) and the Covered Interest Rate Parity (CIP). Can hedging be applied to carry

trades (e.g. thought Future/Forward currency contracts)?

The key motivation is the possible profits that can be made through this type of

operation, especially considering the use of leveraged positions that are usually the

rule in this market, which currently has an expressive size, as mentioned in the

introdutory section of this report. Trying to match the possible and usual returns to

the risk inherent to this type of operation is of central importance in identifying

whether or not they represent a good deal for those operating in this market.

Most of the studies performed in this field up to date don't take into consideration

central points in evaluating carry trade returns, as the real borrowing rates faced by

investors and the actual rates obtained when analyzing investments in real assets,

4

like treasury securities and treasury bonds. This project aims to incorporate the

mentioned items into the equation and evaluate how much the returns are affected.

This project Literature review will be divided in two parts. The first one will look into

studies evaluating carry trade operations profitably, considering their methodologies,

data used and results obtained, aiming to use this information as a comparative

resource to the study that will be presented in this project.

The second part concerns results related to the Uncovered Interest Rate Parity and

Covered Interest Rate Parity, explained in the section 2.2.

Eight papers analyzing historical carry trade profitability were studied in detail, aiming

to identify different study strategies applied, time intervals considered and the returns

and volatilities achieved. A summary of their results will be presented in Table 1,

shown below.

As an example of the strategies used, we can mention a 2014 study of Norges Bank

Investment Management division on currency carry trade. Its methodology was

classifying the currencies according to the interest rates in high, medium and low and

use those that were in the 20% higher positions as destination currencies and those

in the 20% lower positions as funding currencies. The study used 10 different

currencies and a time interval of 1 month, achieving a 5.5% profit (annualized) and

9.1% volatility in the period of 1983 to 2013.

Schrimpf (2012). Here, the strategy used was the division of currencies into 6

portfolios, using the portfolio with the higher interest rate as funds destination (buy

position) and the portfolio with the smaller interest rate as funding (sell position). This

study used 48 different currencies, a time interval of 1 month and achieved a 7.2%

profit (annualized) and 9.8% volatility in the period of 1983 to 2009.

The last one mentioned in this section is the study presented in Brunnermeier, Nagel

and Pedersen (2008). The strategy used here was a one by one combination

5

annualized profit of 6.4% and volatility of 10.2% in the period of 1986 to 2006,

considering a 3-months time interval.

Authors Period Currencies Return Volatility

Norges Bank Investment Management (2014) 19832013 10 5.50% 9.10%

Menkhoff et al. (2012) 19832009 48 7.20% 9.80%

Brunnermeier, Nagel and Pedersen (2008) 19862006 9 6.40% 10.20%

Burnside et al. (2011) 19762009 21 4.80% 5.30%

Darvas (2009) 19762008 11 4.10% 4.60%

Della Corte, Riddiough and Sarno (2012) 19832011 60 5.40% 8.90%

Lustig, Roussanov and Verdelhan (2011) 19832009 35 8.50% 9.00%

Rafferty (2011) 19762011 37 7.00% 8.30%

Source: Prepared by the Author

From Table 1, it can be seen that carry trade operations profitability is highly

dependent on a number of factor, being calculation strategy, time period and time

interval a few of them.

The next review topic concerns a search of studies testing the validity of CIP and

UIP. Studies like the ones presented in Ronald and Taylor (1992) and Coffey, Hrung

and Sarkar (2009) agreed on the fact that CIP does not hold even in the long horizon,

while Bui (2010) defends that this parity might hold on the long run.

Borio, McCauley, McGuire and Sushko (2016) states that Covered Interest Parity

verges on a physical law in international finance. Yet it has been systematically

violated since the Great Financial Crisis. Especially puzzling have been the violations

since 2014, even once banks had strengthened their balance sheets and regained

easy access to funding.

Moving to the Uncovered Interest Rate Parity, Yoshiro and Micheloto (2004) defend

that their research results do not corroborate the uncovered interest parity for the

developing countries in the recent years. Thus, the forward premium puzzle may hold

in the FX emergent markets. On the other hand, for Chinn and Meredith (2004),

Uncovered Interest Parity (UIP) has been almost universally rejected in studies of

6

regressions yield much more support for UIP.

Lastly, according to Bekaert, Wei and Xing (2007), the statistical evidence against

UIRP is mixed and is currency- not horizon-dependent.

In general, the papers studied agreed on one fact: both CIP and UIP do not hold on

the short term. A few of the analysis conduct in this project will also look into

evidence proving or contradicting those theories for the Brazilian market.

2. THEORETICAL REVIEW

Suppose an investor can borrow in the American market at 3% a year and the

interest rate in Brazil is 11% a year, where he is going to invest the money. Also,

consider that the exchange rate was 3.15 USD/BRL when the operation was settled

and the investor borrowed $50 million, which is equivalent to $157.5 million.

After one year, when the operation is going to be unwind, the currency rate is 3.25

USD/BRL, giving:

= = 53.8

.!"# $%

&."#

( ) * +) ), - . / = 50 3% = 1.5

As show above, using borrowed money, the investor made a profit of 2.3mi at the

cost of bearing the risk of a depreciation of the BRL front the USD. In the example,

we had a depreciation of 3.07%. The operation would still be profitable for any

depreciation smaller than 7.08%. Passing this level, the investor would start having a

7

loss, because the gains originated at the investment in a security earning the

Brazilian interest rate would be offset by the payments he needs to make returning

the borrowed money plus 3% interest. Considering that in the last year (2016) the

volatility of this currency pair was over 20%, it can be a very risky trade.

This section aims to give some background on these two well know interest rate

parity conditions: the Uncovered Interest Rate Parity (UIP) and The Covered Interest

Rate Parity (CIP). Together, they provide a framework for discussing the rationale for

various strategies based on their returns.

The CIP is closely aligned to the pricing of Forwards and Futures contracts. The word

'covered' in the context of covered interest parity means bound by arbitrage. CIP

holds when any forward premium or discount is exactly offset by differences in

interest rates, so that an investor would earn the same return investing in either

currency. In other words, the interest rate differential between a high-yielding and a

low-yielding currency will be equal to the spread between the forward and spot

exchange rates of the two currencies, which in turn is the expected change in the

exchange rate plus a risk premium. CIP can be represented by the equation above:

GHIJ

B CDE F NO

Forward;/= = Spot ;/= x KLM

GHIJ

B CDP F NO

, (1)

KLM

where R ; and R = are the interest rates for currency A and B respectively.

As stated in Santaella et. al. (2015) and Schweser CFA Level II notes, Book 1, 2015,

p. 256, equation (1) implies that the earned carry (the interest rate differential) would

equal the cost of hedging the position. Thus, unless there are distortions in the

forward market, an investor writing a forward contract that satisfies CIP has fully

hedged foreign exchange and other risks embedded in the risk premium and will

receive zero excess returns from the interest rate differential.

8

Equation (1) can also be interpreted as the interest rate differential that is implied by

the forward premium. Thus, for a given funding or destination interest rate, it can be

solved for the remaining interest rate.

Moving to the Uncovered Interest Rate Parity (UIP), uncovered here means not

bound by arbitrage. As also stated in Santaella et. al. (2015), it predicts that any

differential between a high-interest rate (destination) currency and a low-interest rate

(funding) currency at ) = 0 will be fully offset by the expected change in the

exchange rate between ) = 0 and ) = 1. Summarizing, the destination currency is

expected to depreciate proportionally so that no gains will be made by investing on it.

The UIP talks about spot rates in different point of time (the current spot rate and the

expected spot rate sometime in the future considering interest rates differentials), and

not about forward rates, like the CIP. It is given by the following equation:

where E %S ;/= is the expected perceptual change in the spot value and R ; and

R = are the interest rates for currency A and B respectively.

In Brazil, we currently have available the 5 types of treasury securities listed below. A

brief discussion will be presented on each of them, focusing on the LTNs, the paper

used in the analysis conducted in this project.

2.3.1 NTN-F

NTN-Fs (National Treasury Note - Series F), also know the "Prefixed Treasury with

Semi-annual Interest", is a fixed-rate security, like the LTNs that were used in this

project. This security makes payment of interest every six months. This means that

the income is received by the investor over the period of the application, unlike in the

9

contracted profitability.

If you need to sell the bond in advance, the National Treasury will pay its market

value, so that the profitability may be higher or lower than that contracted at the date

of purchase, depending on the price of the security at the time of the sale.

2.3.2 NTN-B

NTN-Bs (National Treasury Note - Series B), also known as IPCA Treasury with

Semi-annual Interest (IPCA = Broad National Consumer Price Index), provides real

profitability, that is, it guarantees an increase in the purchasing power of your

investment, because it i is composed of two installments: a fixed interest rate and the

inflation variation (IPCA). Thus, regardless of inflation variation, the total return on the

bond will always be higher than it. The real profitability, in this case, is given by the

fixed interest rate, contracted at the moment of the purchase of the security.

This asset makes interest payments each semester, unlike the IPCA + Treasury

(NTN-B Principal), which means the income is received by the investor over the

period of the application, instead of receiving everything in the end.

10

If you need to sell the bond in advance, the National Treasury will pay its market

value, so that the profitability may be higher or lower than that contracted at the date

of purchase, depending on the price of the security at the time of the sale.

Also known as IPCA Treasury +, differently from the NTN-B, this security has a

simple payment flow, that is, you will receive the amount invested plus the profitability

on the due date of the investment. In other words, the payment occurs at once, at the

redemption date.

Like mentioned for the other treasury securities above, If you need to sell the bond in

advance, the National Treasury will pay its market value, so that the profitability may

be higher or lower than that contracted at the date of purchase.

11

2.3.4 LFT

The LFT, or Treasury Selic, is a post-fixed security attached to the base interest rate

in the Brazilian economy. If the Selic goes up, its profitability goes up together, which

makes the LFT the safest and most conservative option from the range of Brazilian

government bonds.

That is why the Selic Treasury is best suited for scenarios where the Selic rate is

likely to rise or remain high, making this bond look very interesting in times of

financial crisis, when the government usually raises interest rates.

It has a simple payment flow. The investor buys the security and receives its income

only on maturity, in a unique payment. That is, it is not possible to receive semi-

annual interest as in other modalities.

Its profitability is calculated on a daily basis, so you do not receive the Selic rate in

effect at the time of redemption, but rather the daily rate progression over the entire

duration of the title. Also, its market value has very low volatility, which prevents the

investor from being harmed if he sells his title in advance.

12

2.3.5 LTN

The LTN is the security used in the simulations conducted in this project and will be

explained in greater detail here. The National Treasury Letter is the most common

example of a fixed-rate public bond. With it, the investor chooses the year of maturity

and knows exactly the rate of return of the investment.

It has a simple payment flow, that is, you will receive the amount invested plus the

profitability on the due redemption date of the security. Because it does not have

semi-annual coupons, like the NTN-F, the investor does not bear any reinvestment

risk with it.

By holding the asset until maturity, you will receive $ 1,000.00 for each unit of the

paper (if you buy a fraction of the title, the receipt is proportional to the percentage

purchased). The difference between the amount received at the end of the

application and the amount paid at the time of purchase represents the yield of the

security.

13

To calculate the gross profitability of the application, simply use the following formula,

valid for all securities that do not pay coupons:

2*,3 ) - )U = 1

VWXX YZ%[W

\]^ YZ%[W

(3)

The yield found through the above equation represents the investor profit during the

whole time it held the security. To find an equivalent annual yield rate, the following

formula should be used:

1 + 1_`_aX = 1 + 1abb]aX

cd

efe , (4)

in which 1_`_aX equals the rate found in equation (3) and equals the number of

working days during which the security was held.

It should be noted that, between the date of purchase and maturity, the security price

fluctuates depending on market conditions and expectations of future interest rates.

An increase in the market interest rate in relation to the rate that was bought by the

14

investor will cause a decrease in the price of the bond. A decrease in the interest

rate, on the other hand, has the opposite effect. The value of the security in the

investor's portfolio is updated considering these variations. It is updated according to

the price it is traded in the secondary market at that time, procedure known as

"Marking to Market". In the case of an early sale, the National Treasury repurchases

the security based on its market value.

Interpolation is the method that allows one to construct a new dataset from a discrete

set of previously known data points. In building a data curve, most of the time the

values of just a few vertices out of the whole set of points in that curve are available

and in order to build a complete curve, a data interpolation method must be used.

Method".

Kozicki and Gordon (2005). According to this theory, the interest rate of any asset or

derivative contract contains two elements: information on the expectations of the

financial market on the monetary policy during the term of the contract and a

premium to compensate for the investment risk. The average annual return to remain

with a long fixed-income security equals the expected average return on a sequence

of investments in short-term securities.

In the universe of this project, dealing with just financial yield curves, the mentioned

vertices are made of the market values of negotiable contracts maturing in future

dates, with known yields to maturity. Knowing the values of the two adjacent vertices

to a desired point (usually a future date), one can calculate the expected value of the

curve in that point. To do so, the following equation must be used:

15

efe

cdj kcdjkl cdj

cdjpl cdjpl kcdjkl

g /_ = h 1 + g /_i m q r 1,

cdjkl

Cn%WXojpl efe

efe

cdjkl

Cn%WXojkl efe

(5)

In which:

- : number of days in the period;

- ): expiration date;

- ) 1: date of immediately preceding available vertex;

- ) + 1: date of the immediately posterior available vertex.

To clarify this procedure, a numerical example will be given. Suppose you have

available the yields of two vertices of the Brazilian yield curve corresponding to the

following working days and values:

-22 working days: 11.1% _C = 22, 1 + g /_C = 11.1%

Also suppose the value needed is the one corresponding to 15 working days

( _ = 15), which can be found by:

efe

lfklM lf

ee eeklM

g / = s 1 + 10.5% m q u 1 = 10.87%

lM

C . % efe

efe

# lM

C t.#%

(6)

efe

Note the value searched should necessarily be between the two values provided for

10 and 22 working days.

16

The use here is the same explained for flat-forward interpolation: construct a new

dataset from a discrete set of previously known data points.

degree polynomial, to approximate an assumed function 3 v that would originally

represent the images of a discontinuous interval contained in the domain of 3 v .

The linear interpolation between two points va , Ua and vw , Uw can be deduced

using the principle of proportionality:

=

^i^M ^l i^M

xixM xl ixM

, (7)

which gives:

U = Ut + U Ut

xixM

xl ixM

(8)

g /_ = g /_i + F N {_ {_i ,

n%WXojpl in%WXojkl

yzjpl iyzjkl

(9)

in which:

- {: number of running days in the period;

- ): expiration date;

- ) 1: date of immediately preceding available vertex;

- ) + 1: date of the immediately posterior available vertex.

As a numerical example, consider the same values presented in the section above:

17

-22 working days: 11.1% _C = 22, 1 + g /_C = 11.1%

Again suppose the vertex of the curve needed is the one corresponding to 15

working days ( _ = 15), which can be found by:

g /_ = 10.5% + F N 15 10 = 10.75% ,

. %i t.#%

""i t

(10)

The fixed-rate yield curve term structure in Reais is obtained from the BM&F

Bovespa DI futures adjustment prices, using the DI-Over rate disclosed by Cetip

(Custody and Financial Settlement of Securities Central) at the first point of the curve.

The primary source for obtaining the adjustment prices is BM&F Bovespa itself. As

alternative sources, Bloomberg or Reuters can be used.

The DI Futures Contract has as underlying asset the daily average rate of Interbank

Deposits (DI), calculated and disclosed by CETIP, between the trading date,

inclusive, and the expiration date, exclusive, and is used for protection and

management of interest rate risk of assets / liabilities referenced in DI.

The contract has a notional amount of R$ 100,000.00 on the maturity date, and the

value on the negotiation date (PU = Unitary Price) is equal to the amount of R$

100,000.00 discounted by the negotiated rate. As the position is updated daily by the

DI Rate through the updating dynamics of the PU by the correction factor, the

investor who carries the position to maturity receives daily adjustments that add up to

the difference between the interest rate contracted and the realized interest rate on

the amount of the transaction.

build the whole Pr x DI curve (also known as DI x Fixed Rate curve) an

18

above, must be applied, using the contracts' values as vertices.

The methodology used to build the American Dollar x Brazilian Real curve is very

similar to the one explained above for the Pr x DI curve, but now using the maturity

values of futures contracts on American dollar traded on the BM&F Bovespa as

vertices.

The Future Contract on Commercial Dollar is the second most traded derivative

contract in the Brazilian market, second only to the DI Future Contract. By serving for

protection or speculation on the price of the currency at a future date, it is quite

demanded by the market.

The contract may be used as a hedge for investors who, for example, have

receivables in US dollars, or exposure to payments of liabilities in the currency on

future dates or even negotiate on the currency's future trend seeking profit.

Dollar futures contracts are standardized according to their maturity dates (with

maturity dates available until 2025), always maturing on the first business day of the

month. The quotation of this asset is denominated in Brazilian Reais (R$) for US

$1,000.00 (thousand US dollars).

As well as for the Pr x DI curve, the complete assembly of the curve requires the

use of some interpolation method due to the limited number of vertices available.

The future currency coupon contract is the interest rate obtained from the difference

between the accumulated rate on interbank deposits (DI) and the exchange rate in

the period of operation (known as PTAX 800). The negotiation of these contracts

arose in order to replace the combined use of dollar futures and 1-day interbank

deposit contracts by market agents.

19

corresponds to the exchange rate variation plus a fee. This rate is called "Currency

Foreign Exchange Coupon" and is traded on the BM&F Bovespa. It consists of two

components: the DI rate and the dollar. When buying the exchange coupon, the

investor will make a profit if the accumulated CDI rate is higher than the rate of

growth of the dollar, both being in the same period of the operation.

,* | }v~ | {, ., = F 1N 100,

C[]$]Xa_Wo y

CzabW %b x[abW a_W

(11)

cd

F1 + *z N=

yz CZc efe

&t y`X

y`X _

, (12)

in which:

-*y : DI contracts added rate;

- : number of working days in the period;

- {: number of running days in the period;

- , ) : spot rate at contract settlement;

- , 1 : future rate at contract settlement;

Note that the local interest rate is composed, with a calendar of 252 business days

and the US interest rate is linear, with a calendar of 360 calendar days. Now, working

the above equation down, the foreign exchange coupon can be represented by:

20

CZ &t

cd

*z = y`X c 1 yz

efe

(13)

y`X _

The two main factors determining the risk-adjusted profitability of carry trades are: the

interest rate differential between the funding and the target currency, and the

exchange rate risk, as reflected in measures of foreign exchange market volatility.

The former divided by the latter is the so-called carry-to-risk ratio.

position. This measure is based on the interest rate differential that the carry trade

will earn, adjusted for the risk of future exchange rate movements that could erase

the trades profits. A higher value of the carry-to-risk ratio indicates a greater risk-

adjusted ex-ante profitability of a carry trade (Curcuro, Vega, and Hoek, 2010).

profitability of carry trades. For this reason, carry trade activity tends to increase in

periods of low foreign exchange market volatility and to unwind when volatility rises

(European Central Bank Report, 2010, Box 10)

{ =

i

/

, (14)

in which R ; and R = are the interest rates for currency A and B respectively and ;/=

is the volatility of the exchange rate pair analyzed.

21

This section presents information about the data used in the quantitative and

analytical part of this project and their respective sources. For being a quantitative

project, the results obtained in this study are very sensitive to the accuracy of the

information that constitute its building blocks and careful analysis were conducted in

choosing the best available sources for the data needed. The data used in the

simulations conducted in this study were mostly obtained from open sources,

excluding foreign exchange historical rates.

3.1 Software

All the simulations conducted in this project were performed using the software

Microsoft Excel and Microsoft Visual Basic. The choice for these software packages

was based on their interconnection an easy of results visualization and manipulation.

Foreign exchange rates are one of the main building blocks of this project. Although

they can be obtained through many available sources, the chosen one was the

Bloomberg terminal because of the ease in extracting the data in a format that was

already suitable for the simulations and studies that were going to be performed.

Exchange rates from 2002 to June 2017 for the following currency pairs were used:

USD/BRL (American Dollar/Brazilian Reais), MXN/BRL (Mexican Pesos/Brazilian

Reais) and CNY/BRL (Chinese Yuan/Brazilian Reais).

As an example of a free source where this data could also be obtained, the

"Investing.com" website and its FOREX rates section can be mentioned.

22

The other key block of this project was the historical unitary prices of Brazilian

treasury securities. In Brazil, as mentioned in section 2.3, we have fully discounted

treasury securities, securities with semiannual coupons (10% a year), securities

indexed to inflation through the IPCA Index (Broad National Consumer Price Index)

and securities indexed to the Selic, which is the base rate of the Brazilian economy.

For this project, the unitary prices of LTN, a fully discounted treasury security, were

gathered from 2002 (the start date of this type of treasury security) to June 2017.

They were obtained from the official web portal of Brazil's National Treasury

(https://sisweb.tesouro.gov.br), where both buy and sell rates and prices for each

paper of the mentioned security could be downloaded in an excel file showing their

complete set of historical information.

The Pr x DI curve, explained in section 2.6, can be obtained in the BM&F Bovespa

(Brazilian Stock, Commodities, and Futures Exchange - currently known as B3) web

portal (www.bmfbovespa.com), in the following path:

Fixed Rate

BM&F provides data on this curve from 02/January/2004 onwards, which forces our

study to start on this date. The information was extracted from the website through a

Microsoft Visual Basic routine that accesses the curve for each desired date (every

working day from 02/January/2004 to 03/June/2017). Because just selected vertices

of the curve are available, the routine uses the Flat-Forward interpolation technique

(explained in section 2.4) to obtain the other necessary points of the curve that were

not previously available. These data in then plotted into an Excel spreadsheet.

23

The routine used to obtain the Dollar x Brazilian real curve is very similar to the one

detailed in the section above. This curve can be found in the BM&F Bovespa website

in the following path:

x USD

The same Microsoft Visual Basic procedure mentioned for the Pr x DI curve was

applied here, in which the curve from every working day from 02/January/2004 to

3o/June/2017 was extracted. To obtain the necessary curve vertices that were not

available, Linear interpolation (presented in section 2.5) was applied.

The same routine applied for the Dollar x Real curve was executed here, including

the interpolation method used to get the necessary vertices that were not available

(linear interpolation). The path for accessing this data in the BM&F website follows:

Clean ID x USD Spread.

The yield rates of the listed countries were not used in simulations, but as basis for a

comparative analysis performed with the simulated results, requiring a high level of

accuracy in these data. Our results and conclusion would be void if compared simply

with historical reference yield rates, without any calibration for different time horizons.

Preference was given to sources from governmental and administrative web portals

of the studied countries, as follows.

24

United States

Historical yield rates for different time frames can be found in both the U.S.

Department of the Treasury website (www.treasury.gov) and the Federal Reserve

website (www.federalreserve.gov).

Mxico

where rates calculated having Mexico's treasury securities as basis are posted.

Overnight, 4 weeks, 13 weeks, 26 weeks and 52 weeks rates are available.

China

Chinas interest rate history is available at the People's Bank of China website

(www.pbc.gov.cn). As alternative sources, the "Global Rates" website (www.global-

rates.com) and the web portal of the Federal Reserve Bank of St. Louis can be used

to retrieve data for all 3 countries.

To obtain the necessary level of details to perform a comparative study of the topics

mentioned in section 1.1 of this report ("Aims and Objectives"), methodology and

results will be divided in 5 different analyses:

Analysis 1 - Use of real assets and 3 different time horizons: the objective here is

to analyze historical profitability for two different time intervals, January 2004 to

June 2017 and January 2012 to June 2017, for Carry Trade operations with

durations of 1 month, 3 months and 1 year

Analysis 2 - Effect of carrying the asset until maturity: instead of carrying the

assets for fixed amounts of time, the LTNs will be carried to maturity, thus

eliminating any risk related to interest rate movements.

25

Analysis 3 - Real Assets vs. Yield Curve: an analysis of the quality of results

obtained using the Brazilian yield curve as a proxy for studies aiming to access

the effects of operating in this market with real assets (LTNs, in this case).

through the Dollar x Real curve, applied to operations exemplified in the previous

analyses.

Analysis 5 - Hedging both FOREX and Interest Rate exposure: a mixed analysis

of the studies conducted in analysis 2 and 4, aiming to access whether FOREX

Futures market are efficient (arbitrage free) of not;

evaluate their profitability considering the yield curve of the country where funds are

borrowed, the yield curve of the country where funds are going to be invested and

currency exchange rates in desired dates. However, this technique implies a number

of simplifications, like considering investors are able to borrow funds at the risk free

rate of an economy, which is rarely true and will depend on factors like their

perceived credit risk.

To avoid such inconsistency, the goal here will be finding the biggest interest rate at

which someone could borrow money and still profit in the operation, like a "break-

even point", with its foundation in the Covered Interest Rate Parity, discussed in

section 2, "Theoretical Fundamentals". Departing from the CIP, one can reach such

break-even point by transforming the bellow equation as follows:

GHIJ

B CDP F NO

Forward = Spot x R = F &t N = F B1 + R ; F &t NON 1

KLM

GHIJ

B CDE F NO

(15)

KLM

conducted in section 2, that the transformed equation above is equivalent to the

"Foreign Exchange Coupon" concept, represented by equations (11) and (13) in this

report.

26

For part of the studies mentioned above (Analysis 1, 2 and 3), in which no hedge in

FOREX rates is considered, the "Spot" and "Forward" rates mentioned in equation

(15) must be replaced by the exchange rates of the "initial date" and "final date" of

the operations, resulting in the following equation:

R= F N = F B1 + R ; F NON 1

D

&t D "#"

(16)

For the studies in which FOREX rates hedge is considered (Analysis 4 and 5), no

substitution is needed. It must be considered, though, that differently from the CIP, in

which the "Forward rate" is obtained through the spot rate and interest rate

differential, here it will be the point in the currency exchange curve correspondent to

the time horizon desired. This subject will be explained in greater detail in Analysis 5

methodology discussion.

First, the PUs (unitary prices) of all LTNs since the beginning of the issue of the title,

which was in 2002, were sought.

Why LTNs and why unitary prices and not rates? The LTN is the only non-coupon

fixed rate bond, which would eliminate the risk of interest rate movements for those

carrying the bond to maturity (which was not the case in this part of the study).

Because for this part of the study the securities were not carried until their expiration,

the PUs (for buying and selling) are used to calculate the effective yield rate for the

necessary time. Three different intervals were studied: 30, 90 and 252 working days.

Available information on maturities is generally limited, but market intelligence

suggests that carry trades are generally short term (not more than a year) and that

maturities will vary according to the type of investor and instrument (Bank for

International Settlements, 2015, paper 81).

27

Next, historical quotations on the exchange rates of all currency pairs to be studied

(USD/BrL, MXN/BrL and CNY/BRL) were sought. For each working day between

2004 and June 2017, the effective yield rate for someone carrying each of the LTNs

available on that date for the stipulated time intervals (30, 90, and 252 days) was

calculated by dividing the papers' unitary prices (PUs) on the operation end date by

the PU on the beginning date, as previously shown in equation (3). Is worth

mentioning that different PUs are available for buying and selling treasury securities

and this fact was taken into consideration in the simulations.

With the yield rates and the exchange rates' quotations for the time intervals

specified above, the highest rate at which an individual could raise funds in Dollar,

Yuan and Mexican Pesos (and consequently in the US, Mexico and China) and still

profit in the operation was calculated: a kind of "break even rate", which is

represented by Equation (16) above, in which we have:

- - -;

- And the yield rate found by carrying an LTN during the desired time period as .

The results obtained were compared with the effective interest rates in these

countries during the interval studied, in order to evaluate the amplitude of the spread

between the break-even rate and the effective interest rate in these economies.

The average of the results obtained was calculated for the "2004 to 2017" interval

and for the "2012 to 2017" interval (last 5 years). Because most of the time, for the

same date and range, more than one LTN can be available, two methodologies were

used in calculating the averages. In the first one, just the closest to maturity LTN

paper available for each date was considered. For the second one, an average of the

yield rates obtained with each LTN available on a specific date was calculated and

used as the effective yield for that date.

28

Below we have the results found following the methodology described in the section

above for each of the currency pairs and time intervals mentioned. -

In all tables presented in this section and in the next ones to follow, "Methodology 1"

refers to results obtained using just the closest to maturity LTN paper. "Methodology

2" refers to results acquired using an average of the yield rates obtained with each

LTN available on an each specific date.

Table 2: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Brazilian Reais (destination currency) from 2004 to 2017

30 Days 13.82% 14.68%

90 Days 14.03% 15.42%

252 Days 14.29% 15.27%

Source: Prepared by the author using data listed in 4.1.1

Table 3: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Brazilian Reais (destination currency) from 2012 to 2017.

30 Days -0.09% 1.17%

90 Days 1.52% 2.11%

252 Days 1.15% 2.41%

Source: Prepared by the author using data listed in section 4.1.1

Table 4: Average annualized break-even-rates obtained with Mexican Pesos (funding currency)

and Brazilian Reais (destination currency) from 2004 to 2017.

30 Days 18.32% 19.15%

90 Days 17.85% 19.28%

252 Days 17.69% 18.79%

Source: Prepared by the author using data listed in section 4.1.1

29

Table 5: Average annualized break-even-rates obtained with Mexican Pesos (funding currency)

and Brazilian Reais (destination currency) from 2012 to 2017.

30 Days 4.45% 4.72%

90 Days 6.52% 7.52%

252 Days 10.83% 12.27%

Source: Prepared by the author using data listed in section 4.1.1

Table 6: Average annualized break-even-rates obtained with Chinese Yuan (funding currency)

and Brazilian Reais (destination currency) from 2004 to 2017.

30 Days 12.53% 13.36%

90 Days 12.47% 13.88%

252 Days 11.53% 12.62%

Source: Prepared by the author using data listed in section 4.1.1

Table 7: Average annualized break-even-rates obtained with Chinese Yuan (funding currency)

and Brazilian Reais (destination currency) from 2012 to 2017.

30 Days 2.68% 3.61%

90 Days 3.95% 5.58%

252 Days 3.52% 4.89%

Source: Prepared by the author using data listed in section 4.1.1

The next step was simulating the yields for an individual who carried the available

LTN papers on each date until their maturities, regardless of the remaining period of

time. In this case, we would be eliminating the risk of any movement in interest rates.

To do so, the LTN's yield is calculated by dividing R$ 1,000.00, which is the security's

unitary price at maturity by the units purchase price on the date of the beginning of

the operation. Then, for each working day between 2004 and June 2017, the

30

effective structure yield rate (stated in Equation 16) for someone carrying each of the

LTNs available on that date until maturity was calculated taking into consideration the

currency exchange rates for each date of those dates.

As stated in the previous analysis, results were calculated using both the rates

obtained using the LTNs closest to maturity date and the average of the rates

obtained with all the available titles on a date. The rates obtained were annualized so

that comparisons could be made with the results obtained in the other analysis

performed.

Below follows the results found following the methodology described in the section

above (section 4.2.1) for each of the currency pairs mentioned. Because the LTNs

are carried to maturity in this simulation, there is no specific time interval to be taken

into consideration this time. Also, Methodologies 1 and 2 stands for the same

techniques explained in section 4.1.2.

Table 8: Annualized break-even-rates obtained with USD, MXN and CNY as funding currencies

and Brazilian Reais as destination currency from 2004 to 2017.

US Dollar 21.09% 15.87%

Mexican Peso 26.85% 25.00%

Chinese Yuan 23.09% 17.35%

Source: Prepared by the author using data listed in section 4.2.1

Table 9: Average annualized break-even-rates obtained with USD, MXN and CNY as funding

currencies and Brazilian Reais as destination currency from 2012 to 2017.

US Dollar 5.59% 6.65%

Mexican Peso 25.56% 27.55%

Chinese Yuan 10.43% 12.11%

Source: Prepared by the author using data listed in section 4.2.1

31

What is the practical effect of using the yield rates obtained through real assets

(government treasury bonds, in this case) in the simulations instead of the Brazilian

interest rate curve, like done in the study performed in analysis 1 and 2?

For this analysis, a VBA code that could access the interest rate curve (Pre x DI)

available on the BM&F Bovespa website for each business day between 02/01/2004

and 06/30/2017 was developed. Because the vertices for 30, 90 and 252 days were

not always available, the entire curve was built through Flat-Forward interpolation

using the available vertices and the desired points were extracted.

Taking the data mentioned in the above paragraph and the historical quotations of

currency exchange rates used in the previous analysis, the same "break even rates"

were calculated.

Here we have the results found in the simulations that followed the methodology

described in section 4.3.1 for each currency pair and time interval mentioned.

Methodologies 1 and 2, mentioned in previous sections, are not applicable here since

this simulation was done using the Pr x DI curve (ID x Fixed Rate curve) instead of

LTNs.

Table 10: Average annualized break-even-rates obtained with US Dollar, Mexican Peso and

Chinese Yuan as funding currencies and Brazilian Reais as destination currency from 2004 to

2017, using the Pr x DI curve.

30 Days 12.51% 16.61% 11.25%

90 Days 13.14% 16.79% 11.55%

252 Days 13.76% 17.07% 11.04%

Source: Prepared by the author using data listed in section 4.3.1

32

Table 11: Average annualized break-even-rates obtained with US Dollar, Mexican Peso and

Chinese Yuan as funding currencies and Brazilian Reais as destination currency from 2012 to

2017, using the Pr x DI curve.

30 Days 0.29% 7.08% 2.18%

90 Days 0.48% 8.41% 2.86%

252 Days 1.09% 10.52% 3.47%

Source: Prepared by the author using data listed in section 4.3.1

What if we could hedge against the foreign exchange movements? How much this

possibility would improve (or worsen) the results obtained in the first analysis? To do

this, the same VBA code used in the previous item was used, now for the extraction

of the Dollar x Real curve available on the BM&F Bovespa website.

The vertices of this curve represents the market's expectations of the exchange rate

between American Dollars and Brazilian Reais for the foreseeable future and serve

as basis for the establishment of Futures and Forwards contracts involving these two

currencies.

As already explained in the theoretical review section of this report, the "Law of One

Price" states that two securities that present the same payoff and level of risk should

sell for the same price in all markets, thus avoiding any arbitrage opportunity. In order

to agree with such theory, for each date, the structure of the Dollar x Real curve

should follow the interest rates differential in these two economies, i.e., if a fixed-rate

security is yielding 10% a year in Brazil and 2% in the US, it is expected that the

exchange rate USD/BRL will increase by 8% in one year, otherwise, we'll have an

arbitrage opportunity, which represents a deal with no costs and guaranteed profit. If

the exchange rate increases by less than 8%, one could borrow money at 2% a year

in America, exchange the proceeds for Brazilian Reais and invest the money in Brazil

at 10% a year. After this interval, he would exchange the proceeds back to US

Dollars the spot rate on this date, return the borrowed amount plus 2% interest and

33

keep the difference as profit. On the other hand, if the exchange rate was expected

to change by more than 8%, one could structure the deal in the opposite way, by

borrowing proceeds in Brazil and investing in the US.

previously detailed, what is done in this part of this study is an analysis of this rate

once the exchange rate movements are blocked through the use of Forward

contracts on the USD/BRL currency pair.

Once the biggest source of risk in currency carry trades is hedged, we are just left

with the risk of small movements in the yield of the LTNs arousing from the fact that

the securities are not going to be carried to maturity in this part of the analysis.

If the rates found in this part of the study are considerably greater than what is known

to be the interest rate in force in the US for a determined date, a conclusion is

reached that arbitrage opportunities are available for people operating in this market.

This analysis was performed using just the USD/BRL currency pair because the

BM&F Bovespa does not trade Futures on Mexican Pesos and Chinese Yuans and,

consequently, no curve on these currency pairs is published in their website.

(30, 90 and 252 days), the complete curve is build using an interpolation technique.

This time, because we are dealing with a currency curve, linear interpolation was

used and the necessary points were extracted.

The procedure here was almost the same as the one performed in analysis 1, the

only difference being in the "Final Date Exchange Rate". In analysis 1, the rate used

was the currency spot exchange rate on the settlement date of the operation. Now,

this value was substituted by the correspondent vertex on the Dollar x Real curve,

representing the settlement value of a Forward contract on this currency pair for

specific time intervals, thus representing the foreign exchange rate hedge we wanted

to analyse in this section.

OBS: Why foreign exchange exposure should be hedged with Forward and not

Futures?

34

First of all, futures contracts are exchange-traded and, therefore, are standardized

contracts. Forward contracts, on the other hand, are private agreements between two

parties and are not as rigid in their stated terms and conditions. The study conducted

in this part of the project required very specific terms in relation to the time intervals

and settlement dates of the contracts such that complete foreign exchange hedge

was structured.

Secondly, Futures contracts are marked-to-market daily, which means that daily

changes are settled day by day until the end of the contract, requiring margins to be

posted on Clearing Houses. This structure, which usually decreases counterparty risk

to Futures contracts, is an impediment for their use in arbitrage operations like the

one presented here, because of the need of financial proceeds to be posted as

margin.

Here we present the results found in accordance with the methodology section of

analysis 4, in which foreign exchange hedge through the use of currency Forward

contracts was introduced. Below follows Tables 12 and 13, accounting for results

obtained with the USD/BRL currency pair and all three time frames (30, 90 and 252

working days) used. Methodologies 1 and 2 stands for the same techniques

explained in section 4.1.2.

Table 12: Average annualized break-even-rates obtained with US Dollars (funding currency)

and Brazilian Reais (destination currency) from 2004 to 2017, using the Dollar x Real curve for

hedge.

30 Days 3.99% 4.62%

90 Days 3.66% 4.75%

252 Days 6.47% 7.25%

Source: Prepared by the author using data listed in section 4.4.1

35

Table 3: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Brazilian Reais (destination currency) from 2012 to 2017, using the Dollar x Real curve for

hedge.

30 Days 3.13% 3.75%

90 Days 2.70% 3.82%

252 Days 5.03% 5.74%

Source: Prepared by the author using data listed in section 4.4.1

Exposure

In this analysis, both the yield rate and the currency exchange rate to be applied on

the operation's maturity date will be previously known, which will result in an

operation with no market risk.

For operations structure in the currency pair USD/BRL, the LTNs will be carried until

maturity, implying their resulting yields will be known in the time of the purchase of

the papers. Currency exposure will be hedge through Forward contracts considering

the Dollar x Real curve available on each date.

The simulation methodology used here is a mix of the ones used in analysis 2 and

analysis 4. For each day from the beginning of 2004 to June 2017, the values

substituted in equation 16 where:

- Initial Date Exchange Rate: currency exchange spot rate on the beginning of the

operation.

- Final Date Exchange Rate: vertex on the Dollar x Real curve corresponding to the

operation's maturity date.

36

The aim of this section is to determine whether arbitrage opportunities are available

in currency's Future market or not. An arbitrage free market for currency futures

would need to follow the Covered Interest Rate Parity (CIP), explained in section 2.2,

which states that any forward premium or discount in the FOREX market should be

exactly offset by differences in interest rates to avoid arbitrage opportunities.

As stated for analysis 4 (and even more enforced here), if the spread between the

results found in this study and American interest rates are considerable, a conclusion

can be reached that currency Futures market are not efficient.

Here we present the results achieved when both interest rate and foreign exchange

exposure are hedged by carrying the LTNs until maturity and by using Forward

currency contracts, as explained in the methodology section above. Results are

presented in Tables 14 and 15 and again the simulations considered the USD/BRL

currency pair and three different time intervals (30, 90 and 252 working days).

Methodologies 1 and 2 stands for the same techniques explained in section 4.1.2.

Table 4: Average annualized break-even-rates obtained with US Dollars (funding currency) and

Brazilian Reais (destination currency) from 2004 to 2017, using the Dollar x Real curve for

hedge.

LTNs carried to maturity 17.87% 22.09%

Source: Prepared by the author using data listed in section 4.5.1

Table 15: Average annualized break-even-rates obtained with US Dollars (funding currency)

and Brazilian Reais (destination currency) from 2012 to 2017, using the Dollar x Real curve for

hedge.

LTNs carried to maturity 5.58% 6.64%

Source: Prepared by the author using data listed in section 4.5.1

37

5.1 Analysis 1

From Analysis 1, pertaining data contained in Tables 2 to 7, we can conclude that the

most profitable currency pair to enter into a carry trade operation using real securities

(LTNs in this case) is the MXN/BRL (Mexican Pesos x Brazilian Reais) independently

of the time interval (30, 90 or 252 working days) and moment in time (2004 to 2017 or

2012 to 2017).

Within the same currency pair, there is no consensus of which time interval is the

best option. In general, the 1-year time interval had better results. The volatility of

currency exchange rates, which is the greater source of risk in carry trade operations,

tends to increase in broader time intervals (as illustrated for the USD/BRL currency

pair in table 15), bringing sense to the results found. From a risk-reward perspective,

the operations should need to be more profitable in long time intervals to compensate

investors for bearing more risk.

Table 16: Average volatility for the USD/BRL currency pair considering different time intervals

(1 month, 3 months and 1 year)

1 month 3.72% 4.43%

3 months 6.49% 8.02%

1 year 15.62% 20.49%

Source: Prepared by the author using currency exchange rates provided by Bloomberg

The volatilities presented in Table 16 were calculated using a sliding window for each

time interval, being the results presented an average of the values found.

A fact worth mentioning is that despite the considerable increase in the exchange

rate volatility when we compare the values found for 2012-2017 to 2004-2017 values,

the break-even-rates were notably smaller (sometimes even negative) for this time

period. Even with substantial interest rates in Brazil during the former mentioned

period (reaching values of more than 14% a year), the movements in currency

38

exchange rates in the post Brazilian political crises moment that started after the

presidential elections in 2014 were huge, with great devaluation of the Brazilian Real

front the US Dollar and other major currencies. In this period, investors were not

compensated for bearing currency exchange rate risk inherent to carry-trade

operations.

Another specific easily noticed in the analysis of simulation numbers presented in the

tables above is the superiority of results obtained via Methodology 2 when compared

to Methodology 1 for all currency pairs, time intervals (30, 90 and 252 days) and time

periods (2004 to 2017 and 2012 to 2017).

This specific would be in accordance with widely accepted financial theories, like the

one know as "riding the yield curve". The most straightforward strategy for a bond

investor is "maturity matching", i.e., purchasing bonds that have a maturity equal to

the investor's investment horizon.

superior returns may pursue a strategy called "riding the yield curve" (also known as

"rolling down the yield curve"). Under this strategy, an investor will purchase bonds

with maturities longer than his investment horizon. In an upward-sloping yield curve,

shorter maturity bonds have lower yields than longer maturity bonds. As the bond

approaches maturity (i.e., rolls down the yield curve), it is valued using successively

lower yields and, therefore, at successively higher prices (Bieri and Chincarini, 2005).

If the yield curve remains unchanged over the investment horizon, riding the yield

curve strategy will produce higher returns than a simple maturity matching strategy,

increasing the total return of a bond portfolio. The greater the difference between the

forward rate and the spot rate, and the longer the maturity of the bond, the higher the

total return.

The rates obtained through Methodology 2 were calculated using an average of the

rates gotten by carrying each LTN paper available on a given date during a

determined time window (30, 90 or 252 working days). In most of the cases, the

strategy included carrying (and "selling") treasury securities that were far from their

maturity dates, achieving superior results for that, according to the theory just

explained.

39

5.2 Analysis 2

Here, results presented in Analysis 2 are compared with the ones obtained in

Analysis 1, with the aim of identifying the better manner to operate in carry-trades

using LTNs: holding the papers for fixed amounts of time (1 month, 3 months or 1

year) or carrying the securities until their maturities, independently of their remaining

time.

As can be seen when the results of Table 8 is compared with the results of Tables 2

to 4 and the results of Table 8 is compared with the results of Table 5 to 7, carrying

the LTNs to maturity is always the best strategy, independently of the currency pair in

question or the time period (2004-2017 or 2012-2017). The difference of the results

obtained with the strategy presented in Analysis 2 when compared to those of

Analysis 1 is considerable. For the USD/BRL pair, the gain is of at least 5%. For the

MXN/BRL pair, the gain is of about 8% for the 2004-2017 period and more than 10%

for the 2012-2017 period. Lastly, for the CNY/BRL pair, we have a gain of about 7%

in average.

5.3 Analysis 3

Tables 17 to 19, shown below, present a comparison between the results obtained

using the strategy explained in Analysis 1 with that explained in Analysis 3, aiming to

show that the use of interest rate values acquired with the use of the Pr x DI curve

constitute a fair approximation of those obtained with the use of LTNs.

.

40

Table 17: Comparison between average annualized break-even-rates obtained with US Dollars

as the funding currency, using different calculation techniques.

Time Interval (2004-2017) Methodology 1 Methodology 2 Pr x DI Curve

30 Days 13.82% 14.68% 12.51%

90 Days 14.03% 15.42% 13.14%

252 Days 14.29% 15.27% 13.76%

Time Interval (2012-2017) Methodology 1 Methodology 2 Pr x DI Curve

30 Days -0.09% 1.17% 0.29%

90 Days 1.52% 2.11% 0.48%

252 Days 1.15% 2.41% 1.09%

Source: Prepared by the author using data listed in section 4.1.1 and 4.3.1

Table 18: Comparison between average annualized break-even-rates obtained with Mexican

Pesos as the funding currency, using different calculation techniques.

Time Interval (2004-2017) Methodology 1 Methodology 2 Pr x DI Curve

30 Days 18.32% 19.15% 16.61%

90 Days 17.85% 19.28% 16.79%

252 Days 17.69% 18.79% 17.07%

Time Interval (2012-2017) Methodology 1 Methodology 2 Pr x DI Curve

30 Days 4.45% 4.72% 6.08%

90 Days 6.52% 7.52% 7.41%

252 Days 10.83% 12.27% 10.52%

Source: Prepared by the author using data listed in section 4.1.1 and 4.3.1

Table 19: Comparison between average annualized break-even-rates obtained with Chinese

Yuans as the funding currency, using different calculation techniques.

30 Days 12.53% 13.36% 11.25%

90 Days 12.47% 13.88% 11.55%

252 Days 11.53% 12.62% 11.04%

Time Interval (2012-2017) Methodology 1 Methodology 2 Pr x DI Curve

30 Days 2.68% 3.61% 2.18%

90 Days 3.95% 5.58% 2.86%

252 Days 3.52% 4.89% 3.47%

Source: Prepared by the author using data listed in section 4.1.1 and 4.3.1

41

The results obtained with the use of the Pr x DI curve are very similar to the ones

obtained with calculus Methodology 1, being the former in most cases in an interval

of approximately 1% above or below the latter.

In general, methodology 2 results are more expressive (bigger) and more difficult to

approximate by the use of the Pr x DI curve.

For comparison purposes, Graphs 1 illustrates the 1-year break even rates for the

USD/BRL currency pair and Graphs 2 illustrates the 30-days break even rates for the

CNY/BRL currency pair along the 2012 to 2017 time period obtained with the

strategies listed above (Methodology 1 and 2 and Pr x DI curve), corroborating the

analysis presented in the past few paragraphs. The similarity of the results obtained

with Methodology 1 and the Pr x DI curve for US Dollars and Chinese Yuan is

noticeable in Graph 1 and Graph 2. As an observation, the interest rates presented in

Graph 2 are not annualized.

Pr x DI curve

42

x DI curve.

5.4 Analysis 4

are un-hedged operations and when arbitrage theory is introduced, by its nature,

completely hedged operations shouldn't result in any profit. All the background

supporting these claims were explained in section 4.4.1.

Here, investors still bear some level of risk related to movements in the interest rate

curve, so, in theory; they are still entitled to some reward for that. As expected, in

some situations there was a considerable profit loss caused by the currency hedge.

However, unexpectedly, for the period covering the years of 2012 to 2017, in which

great volatility was present in the FOREX market for the USD/BRL currency pair,

more expressive results were achieved by hedging currency risk, which means that in

high volatility moments, investors were not compensated by taking this type of risk.

Below, Tables 20 and 21 show the level of volatility of the break even rates for each

of the strategies analysed while Table 22 and 23 present a comparison of the

average annualized yield rates.

43

The volatilities were calculated using a sliding window of the same size of the time

intervals being analyzed in each item.

Table 20: Break even rates volatility with and without the use of FOREX hedge for the USD/BRL

currency pair, using Methodology 1 for the calculation of yield rates.

30 Days 2.60% 0.96%

90 Days 4.64% 1.02%

252 Days 10.72% 1.54%

Time Interval (2012-2017) Methodology 1 (without hedge) Methodology 1 (with hedge)

30 Days 2.52% 0.96%

90 Days 4.87% 1.02%

252 Days 11.40% 1.57%

Source: Prepared by the author using data listed in section 4.1.1 and 4.4.1

Table 21: Break even rates volatility with and without the use of FOREX hedge for the USD/BRL

currency pair, using Methodology 2 for the calculation of yield rates.

30 Days 2.73% 1.09%

90 Days 4.94% 1.35%

252 Days 11.07% 2.30%

Time Interval (2012-2017) Methodology 2 (without hedge) Methodology 2 (with hedge)

30 Days 2.76% 1.22%

90 Days 5.57% 1.67%

252 Days 13.21% 2.89%

Source: Prepared by the author using data listed in section 4.1.1 and 4.4.1

44

Table 22: Yield rates comparison for the break even rates obtained using Methodology 1 for the

USD/BRL currency pair.

30 Days 13.82% 3.99%

90 Days 14.03% 3.66%

252 Days 14.29% 6.47%

Time Interval (2012-2017) Methodology 1 (without hedge) Methodology 1 (with hedge)

30 Days -0.09% 3.13%

90 Days 1.52% 2.70%

252 Days 1.15% 5.03%

Source: Prepared by the author using data listed in section 4.1.1 and 4.4.1

Table 23: Yield rates comparison for the break even rates obtained using Methodology 2 for the

USD/BRL currency pair.

30 Days 14.68% 4.62%

90 Days 15.42% 4.75%

252 Days 15.27% 7.25%

Time Interval (2012-2017) Methodology 2 (without hedge) Methodology 2 (with hedge)

30 Days 1.17% 3.75%

90 Days 2.11% 3.82%

252 Days 2.41% 5.74%

Source: Prepared by the author using data listed in section 4.1.1 and 4.4.1

The most adequate way to analyse the results presented above would be through the

use of a risk-reward ratio. Our chosen ratio is represented by:

\ZWa Wb a_W n%WXo

(17)

Bigger values for the ratio represents superior results, meaning that each additional

unit of risk taken by the investor (by not hedging currency risk) is compensated with

more expressive rewards. Tables 24 and 25 below show the results of Table 22

45

divided by the results of Table 20 and the numbers of Table 23 divided by those of

Table 21 aiming to represent the ratio just explained.

Table 24: Risk-Reward ratios for the break even rates obtained using Methodology 1 for the

USD/BRL currency pair.

30 Days 5.31 4.15

90 Days 3.02 3.59

252 Days 1.33 4.19

Time Interval (2012-2017) Methodology 1 (without hedge) Methodology 1 (with hedge)

30 Days -0.04 3.27

90 Days 0.31 2.66

252 Days 0.10 3.20

Source: Prepared by the author using data presented in Table 20 and Table 22.

Table 25: Risk-Reward ratio for the break even rates obtained using Methodology 2 for the

USD/BRL currency pair.

30 Days 5.38 4.25

90 Days 3.12 3.53

252 Days 1.38 3.16

Time Interval (2012-2017) Methodology 1 (without hedge) Methodology 1 (with hedge)

30 Days 0.42 3.08

90 Days 0.38 2.29

252 Days 0.18 1.99

Source: Prepared by the author using data Table 21 and Table 23.

The ratios confirm that, removing the results obtained for the 30-day time interval for

the 2004-2017 period in both methodologies, it is always advantageous to hedge

currency risk. Results are even more expressive for the 2012-2017 period when, due

the financial crises in Brazil, volatility in the FOREX market had a great increase.

46

5.5 Analysis 5

First, we want to start this analysis with a comparison between the results presented

in section 4.2.2 and section 4.5.2, both obtained using the same strategy of carrying

the available LTNs at each date until their maturity date, which eliminates any related

interest rate movement risk to the strategy . Section 4.5.2 added an additional layer

of risk hedge to the strategy: currency hedge. Now, we are left with a completely

hedged position.

Again, we'll be working just with the USD/BRL currency pair in this section. As

already mentioned, hedge de-characterizes the operation as being a Carry Trade

operation. However, the objective here is to show advantages of operating in this

market using this alternative mechanism, which exploits market imperfections in the

pricing of Forward contracts in the USD/BRL currency pair.

Table 26 shows a comparison between the results obtained with and without

currency hedge.

Table 26: Average annualized break-even-rates for the USD/BL currency pair, with and without

currency hedge, using the Dollar x Real curve for hedge.

Without Hedge 15.87% 21.09%

With Hedge 17.87% 22.09%

Time Interval (2012-2017) Methodology 1 Methodology 2

Without Hedge 5.59% 6.65%

With Hedge 5.58% 6.64%

Source: Prepared by the author using data listed in section 4.5.1

Results obtained with hedge were very close or even superior to the ones obtained

without hedge, concurring with what was presented in section 5.4. The aim of this

section, however, is to draw attention to the inefficiency of FOREX Futures market.

theory. Data presented in section 5.4, in Table 26 and with the aid of Table 27,

presented below, help to prove the opposite.

47

Table 27 presents the average interest rate in the Unites States, valid for different

time intervals, for the time periods of 2004 to 2017 and 2012 to 2017. Our break even

rates represent the rate at which an investor would have 0 profits in a carry trade

operation with borrowing money in the funding currency at that rate. If we consider

the rates at Table 27 as the borrowing rates, the real profit would be the spread

between the break even yield rates and Table 27 rates. The bigger the borrowing

rate, the smaller the spread and, consequently, the profit.

Table 27: Average annualized interest rates for the United States of America in different time

periods and intervals.

30 Days 1.18% 0.58%

90 Days 1.24% 0.75%

252 Days 1.47% 0.82%

Source: Prepared by the author using data listed in section 3.7

Having a close look at the yield rates presented throughout section 5.4 and in Table

26, the spread between the values obtained through Methodology 1, Methodology 2

and by carrying the LTNs until maturity in relation to the values presented in Table 27

are considerable, creating a concrete profit possibility, even when market frictions

and externalities (like transaction costs and credit grade of the borrower) are taken

into consideration, proving the Brazilian FOREX Futures market is not efficient.

48

CONCLUSION

From the studies conducted and comparative analysis performed between the

achieved results, a number of conclusions can be draw. A summary of those will be

described here.

The first one is regarding the time frame of the operations. Operations performed

along extended time period (e.g. 1 year) tend to perform better than short term

operations for all the currency pairs studied. Market-wise, long time intervals are not

the rule, as show in Table 1, because of the risk inherent to this type of operation

coming from foreign exchange movements. However, extending the time interval

historically comes with a reward for the increased risk.

The second conclusion is about the best strategy to be applied in carry trade

operations using pure discount fixed-rate securities. Carrying the asset until their

maturity date always achieved better results than selling them beforehand.

When not following the rule just described of carrying the papers until maturity, a

conclusion can also be draw regarding whether to opt for Methodology 1 or

Methodology 2, described and used alongside this report. Methodology 2, which

consists of an average of the rates obtained through carrying each of the LTN

available on each date during specific time intervals (30, 90 and 252 business days)

always results in superior results when compared to Methodology 1, in which just the

paper closest to maturity is carried.

The next conclusion is about the use of the Pr x DI curve as a proxy for use in

analysis previously conducted with the LTN (comparison of Analysis 1 and 3). The

results obtained with the Pr x DI curve can be used in place of the LTNs yield-rates

with no significant loss of accuracy. The Pr x DI curve results were always within a

1% interval range from the original results.

When currency hedge is introduced, the simulation results achieved were improved

in the great majority of the cases. The level of risk, as analyzed by the risk-reward

ratio introduced in section 5.4, also decreased, meaning that investors bear less risk

and achieve greater levels of profit by the introduction of currency hedge. Investors

were not compensated for bearing this type of risk in their portfolios.

49

Lastly, when analysing a combination of currency hedge and interest rate hedge, by

using the strategy of carrying the LTNs until maturity, and comparing the break even

rates achieved with historical interest rate level in the Unites States, it can be seen

that expressive levels of profit, calculated by the spread of the break even rates and

American interest rates for a given date, are achieved. These results constitute

violations of the CIP and consequently, the arbitrage theory, since operations with no

considerable level of risk can be structured such to achieve substantial level of profit.

As already detailed, our choice for the calculation of break even rates, and not profit

rates, prevents these results from being directly compared with those listed in the

Literature Section of this report. In common, however, they have the fact that both

defend the profitability of carry trade operations and violations of the CIP in this

market.

In the group of details that could influence these report results, we have transaction

costs and credit risk levels. For the numbers obtained in the simulations and analysis

conducted here, the former wouldn't represent a major drawdown.

currency pairs other than USD/BRL, aiming to analyse whether the achieved results

are currency

50

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BURNSIDE, Craig, EICHENBAUM, Martin, and REBELO, Sergio , Carry trade: The

gains of diversification. Journal of the European Economic Association 6(23), pp.

581588. 2008

DARVAS, Zsolt. Leveraged carry trade portfolios. Journal of Banking and Finance

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DELLA CORTE, Pasquale, RADDIOUGH, Steven, and SARNO, Lucio. Currency premia

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BIERI, David S., CHINCARINI, Ludwig B. Riding the Yield Curve: A Variety of

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