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Consider this interview question:

Tell me how you'd construct a risk neutral cross country trade on the 2 year – 10 year interest rate spread in Germany and the U.S.

  1. What does "risk neutral" mean in this context? It surely can't mean "indifferent to risk" in the context of derivatives pricing.

  2. How would you answer the interview question? I thought of trading interest rate swaps, but they only work for one currency, unless I'm mistaken.

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  • $\begingroup$ A lot of unclear jargon, I agree. I think he wants a 2-10 spread trade in the US, and another in Germany in the opposite direction (so steepener in Ger plus flattener in US or vice-versa). So it is going to be a 4 legged trade, using swaps or using bonds. The two opposite sides to have equal risk (?). That's my guess... $\endgroup$ – noob2 Feb 4 '19 at 1:45
  • $\begingroup$ @noob2 is correct in his interpretation. The question is, what amount of US 2-10 steepener offsets a given amount of Ger 2-10 flattener. You have to do a regression of recent moves in one spread versus the other to get the hedge ratio. $\endgroup$ – dm63 Feb 4 '19 at 2:38
  • $\begingroup$ @dm63 Could you share any sample document/resource explaining the kind of trade you're talking about? Just if I understand correctly, you're saying regress 2-10 steepner US over 2-10 GER flattener. The correlation/$\beta$ is the hedge amount? $\endgroup$ – user23564 Feb 4 '19 at 5:36
  • $\begingroup$ @noob2 Unless the swap references Bund and Schatz rates (unlikely because of credit risk), it would be on an EUR rate and hence not Germany-specific. Trading the Bund vs the Schatz futures and 2Y vs 10Y UST note futures would seem to be the best way to do this. I think you would also need to trade futures on USD/EUR to eliminate the FX risk. Terrible terminology though: "risk neutral" presumes the slope factor in the US and Germany have the same underlying risk... which is just not so. $\endgroup$ – kurtosis Aug 19 '20 at 2:18

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