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FUNDAO GETULIO VARGAS

CURSO MASTER CEBANKING


TRABALHO DE CONCLUSO DE CURSO TCC

GABRIELA DA CUNHA MACIEL

Currency Carry Trade Operations: a Quantitative


Analysis of Profitability and Optimal Terms of Operation

So Paulo - SP
2017
II

GABRIELA DA CUNHA MACIEL

Currency Carry Trade Operations: a Quantitative


Analysis of Profitability and Optimal Terms of Operation

Rogrio Mori
(Coordenador Acadmico)

Guido Chagas
(Professor Orientador)

Trabalho de Concluso de Curso apresentado ao curso MASTER


CEBANKING de Ps-Graduao Lato Sensu, Nvel de Especializao
da Escola de Economia de So Paulo/FGV/EESP para obteno do
ttulo de Especialista.

TURMA: CURSO MASTER CEBANKING - 1 Sem./2016

SO PAULO - SP
2017
III

Currency Carry Trade Operations: a Quantitative


Analysis of Profitability and Optimal Terms of Operation

Elaborado por: Gabriela da Cunha Maciel e aprovado pela Coordenao


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

Data de Aprovao: _____________________

Rogrio Mori
Coordenador Acadmico

Guido Chagas
Professor Orientador
IV

TERMO DE COMPROMISSO

A aluna Gabriela da Cunha Maciel, abaixo-assinado, do Curso MASTER


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.

So Paulo, 13 de Agosto de 2017

_______________________________

Gabriela da Cunha Maciel


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

Brazilian Reais (destination currency) from 2004 to 2017 __________________________________ 05

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

Brazilian Reais (destination currency) from 2004 to 2017 __________________________________ 28

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

Brazilian Reais (destination currency) from 2012 to 2017. _________________________________ 28

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

Brazilian Reais (destination currency) from 2004 to 2017. _________________________________ 28

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

Brazilian Reais (destination currency) from 2012 to 2017. _________________________________ 29

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

Brazilian Reais (destination currency) from 2004 to 2017. _________________________________ 29

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

Brazilian Reais (destination currency) from 2012 to 2017. _________________________________ 29

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. ________________________________ 30

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

month, 3 months and 1 year) ________________________________________________________ 37

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

funding currency, using different calculation techniques. __________________________________ 40

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

as the funding currency, using different calculation techniques. _____________________________ 40

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

as the funding currency, using different calculation techniques. _____________________________ 40

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

USD/BRL currency pair. ____________________________________________________________ 44

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

USD/BRL currency pair. ____________________________________________________________ 44

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

currency pair. ____________________________________________________________________ 45

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

currency pair. ____________________________________________________________________ 45

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

and intervals. ____________________________________________________________________ 47


VIII

List of Figures

Figure 1: NTN-F - Payment Structure ____________________________________________________________ 9

Figure 2: NTN-B - Payment Structure ___________________________________________________________ 10

Figure 3: NTN-B Principal - Payment Structure ___________________________________________________ 11

Figure 4: LFT - Payment Structure ______________________________________________________________ 12

Figure 5: LTN - Payment Structure _____________________________________________________________ 13


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

4.1.2 Results - Analysis 1 ........................................................................................ 28


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

A carry trade operation is a strategy in which an investor borrows a certain currency


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.

According to a 2014 study conducted by Bert Dohmen, published in Forbes


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

1.1 Aims and Objectives

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:

Analysis of incentive levels to this type of operation, as can be measured by the


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)?

1.2 Project Motivation

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.

1.3 Literature Review

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.

The next example is an analysis conducted in Menkhoff, Sarno, Schmeling and


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

between each of the 9 currency pairs considered in their analysis, achieving an


annualized profit of 6.4% and volatility of 10.2% in the period of 1986 to 2006,
considering a 3-months time interval.

Table 1 - Literature Review - Summary


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

exchange rate movements considering short horizon data, while long-horizon


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

2.1 Carry Trade Examples

Here follows a straightforward example of how a carry trade operation works.


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:

= 157.5 1 + 11% = 174.825

= = 53.8
.!"# $%
&."#

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

1,) ), - . / = 50 + 1.5 = 51.5

2*,3 ) = 53.8 51.5 = 2.3

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.

2.2 CIP and UIP

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:

E %S ;/= = R= R;, (2)

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.

2.3 Treasury Securities - Prices and Rates

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

LTN. The semi-annual payments, in this case, represent an anticipation of the


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.

The Image bellow illustrates the payment flux of this security.

Figure 1: NTN-F - Payment Structure

Source: Prepared by the Author.

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.

The Image bellow illustrates the payment flux of this security.

Figure 2: NTN-B - Payment Structure

Source: Prepared by the Author.

2.3.3 NTN-B Principal

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.

The payment flux of this security is illustrated in the image bellow:


11

Figure 3: NTN-B Principal - Payment Structure

Source: Prepared by the Author.

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.

Bellow follows an illustration of the payment flux of this security:


12

Figure 4: LFT - Payment Structure

Source: Prepared by the Author.

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.

The Image bellow illustrates the payment flux of this security.


13

Figure 5: LTN - Payment Structure

Source: Prepared by the Author.

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.

2.4 Flat-Forward Interpolation

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.

One of those methods is known as "Flat-Forward" or "Exponential interpolation


Method".

The basis of the Flat-Forward methodology is the Theory of Expectations, shown in


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:

-g /: interest rate expressed based on 252 working days;


- : 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:

-10 working days: 10.5% _i = 10, 1 + g /_i = 10.5%


-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

2.5 Linear Interpolation

The use here is the same explained for flat-forward interpolation: construct a new
dataset from a discrete set of previously known data points.

Linear Interpolation is an interpolation method that uses a linear function . v ,a first-


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)

The above equation can be translated into:

g /_ = g /_i + F N {_ {_i ,
n%WXojpl in%WXojkl
yzjpl iyzjkl
(9)

in which:

-g /: interest rate expressed based on 360 running days;


- {: 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

-10 working days: 10.5% _i = 10, 1 + g /_i = 10.5%


-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)

2.6 Fixed Rate Yield Curve

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.

Because DI future contracts have a limited number of maturity dates available, to


build the whole Pr x DI curve (also known as DI x Fixed Rate curve) an
18

interpolation technique, like the Flat-Forward or Linear interpolation mentioned


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

2.7 DOLLAR vs. REAL Curve

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.

2.8 Foreign Exchange Coupon

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

In other words, the foreign exchange coupon is a security whose remuneration


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.

In a simplified manner, it can be calculated by:

,* | }v~ | {, ., = F 1N 100,
C[]$]Xa_Wo y
CzabW %b x[abW a_W
(11)

or, in more detail, we have:

cd

F1 + *z N=
yz CZc efe
&t y`X
y`X _
, (12)

in which:

-*z : foreign exchange coupon rate;


-*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 _

2.9 Carry-to-Risk Ratio

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.

The carry-to-risk ratio measures the ex-ante, risk-adjusted profitability of a carry-trade


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).

Large exchange rate movements may have important repercussions on the


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)

The carry-to-risk ratio is represented by the following equation:

{ =
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

3. DATA AND RESOURCES

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.

3.2 Foreign Exchange Historical Rates

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

3.3 Treasury Securities Historical Unitary Prices

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.

3.4 Fixed Rate Yield Curve

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:

Services Reports Derivatives Reference Prices Reference Rates ID x


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

3.5 DOLLAR vs. REAL Curve

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:

Services Reports Derivatives Reference Prices Reference Rates BRL


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.

3.6 Exchange Coupon Curve

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:

Services Reports Derivatives Reference Prices Reference Rates


Clean ID x USD Spread.

3.7 United States, Mexico and China Historical Yield Rates

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

Interest rates are available at Mxico Central Bank's website (www.banxico.org.mx),


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.

4. METHODOLOGY AND RESULTS

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).

Analysis 4 - Hedging FOREX Exposure: evaluation of the use of currency hedge,


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;

The usual methodology applied when analyzing Carry Trade operations is to


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

It is easy to notice, after a careful analysis of the theoretical fundamentals review


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.

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

4.1.1 Methodology - Analysis 1

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:

-The currency spot rate in the beginning of the operation as the


- - -;

-The currency spot rate in the settlement date as the - -;

- 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

4.1.2 Results - Analysis 1

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

Time Interval Methodology 1 Methodology 2


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.

Time Interval Methodology 1 Methodology 2


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.

Time Interval Methodology 1 Methodology 2


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.

Time Interval Methodology 1 Methodology 2


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.

Time Interval Methodology 1 Methodology 2


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.

Time Interval Methodology 1 Methodology 2


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

4.2 Analysis 2 - Carrying the Assets Until Maturity

4.2.1 Methodology - Analysis 2

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.

4.2.2 Results - Analysis 2

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.

Currency Methodology 1 Methodology 2


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.

Currency Methodology 1 Methodology 2


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

4.3 Analysis 3 - Real Assets vs. Yield Curve

4.3.1 Methodology - Analysis 3

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.

4.3.2 Results - Analysis 3

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.

Time Interval US Dollar Mexican Peso Chinese Yuan


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.

Time Interval US Dollar Mexican Peso Chinese Yuan


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

4.4 Analysis 4 - Hedging Foreign Exchange Exposure

4.4.1 Methodology - Analysis 4

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.

Because what is searched in this project is the "break-even" borrowing rate


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.

Also, as previously mentioned, in the eventual unavailability of the required vertices


(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.

4.4.2 Results - Analysis 4

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.

Time Interval Methodology 1 Methodology 2


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.

Time Interval Methodology 1 Methodology 2


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

4.5 Analysis 5 - Hedging Both Foreign Exchange and Interest Rate


Exposure

4.5.1 Methodology - Analysis 5

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.

-R ; : yield rate obtained by carrying the LTN until maturity


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.

4.5.2 Results - Analysis 5

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.

Time Interval Methodology 1 Methodology 2


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.

Time Interval Methodology 1 Methodology 2


LTNs carried to maturity 5.58% 6.64%
Source: Prepared by the author using data listed in section 4.5.1
37

5. RESULT ANALYSIS AND COMPARISONS

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)

Time Interval Volatility (2004-2017) Volatility (2012-2017)


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.

However, with an upward-sloping interest rate term structure, investors seeking


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.

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


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.

Graph 1: USD/BRL 1-year break-even rates: Methodology 1 vs Methodology 2 vs


Pr x DI curve

Source: Prepared by the author using data presented in Table 17.


42

Graph 2: CNY/BRL 30 days break-even-rates: Methodology 1 vs Methodology 2 vs Pr


x DI curve.

Source: Prepared by the author using data presented in Table 19.

5.4 Analysis 4

Section 4.4 introduced currency hedged in the analysis. By definition, carry-trades


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.

Time Interval (2004-2017) Methodology 1 (without hedge) Methodology 1 (with hedge)


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.

Time Interval (2004-2017) Methodology 2 (without hedge) Methodology 2 (with hedge)


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.

Time Interval (2004-2017) Methodology 1 (without hedge) Methodology 1 (with hedge)


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.

Time Interval (2004-2017) Methodology 2 (without hedge) Methodology 2 (with hedge)


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 `Xa_%X%_^


\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.

Time Interval (2004-2017) Methodology 1 (without hedge) Methodology 1 (with hedge)


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.

Time Interval (2004-2017) Methodology 1 (without hedge) Methodology 1 (with hedge)


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.

Time Interval (2004-2017) Methodology 1 Methodology 2


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.

A completely hedged operation should have a 0 profit according to the Arbitrage


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.

Time Interval Average - 2004 to 2017 Average - 2012 to 2017


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.

As advisable further studies, we have the application of analysis 4 and 5 to other


currency pairs other than USD/BRL, aiming to analyse whether the achieved results
are currency
50

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