I was reading an article and i saw this :

Fund managers based outside the eurozone can profit from buying Europe’s negative-yielding government debt thanks to an uplift from hedging the currency. That is because such hedges are based on the relative levels of short-term interest rates. These are much higher in the US than in the euro zone, meaning dollar- based investors are effectively paid to hedge their euro exposure back into dollars. For instance, a two-year German Bund currently yields around minus 0.88 per cent. However, after hedging the currency, this becomes a positive yield of around 1.9 per cent for dollar-based investors. For a US-based investor, this is better than buying a two-year Treasury.

I don't understand the reasoning behind this. If you convert USD to EUR, then buying negative yield bond in eurozone, you lose money. How hedging the currency can counter balance it ?


For a US investor to hedge the bonds the investor would (1) Buy EURUSD in the Spot market, (2) Buy the German bonds with the EUR proceeds, (3) Short EURUSD in the forward market to provide a guaranteed repatriation rate when the bonds mature (thus avoiding FX risk).

Currently the two year forward exchange premium/discount for the EURUSD is 532 forward points (source) and the spot rate is 1.1052 (source) so the two year forward rate is 1.1584.

Let's say I start with 1000 USD, I exchange it for 1000/1.1052 = 904.8136 EUR. I buy the German bonds. In two years I expect to have 904.8136*(1-0.0088)^2 = 888.95895 EUR because of the negative interest rate. This will give me 888.95895*1.1584 = 1029.77 USD. In dollars I have made a profit of 29.77 or earned a yield of about 1.47% a year).

[The rates have been changing recently, so it does not quite match the calculation in your article].

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    $\begingroup$ US 2Y rate is about 1.77 (source: treasury.gov/resource-center/data-chart-center/interest-rates/…) so it would be better. But this is just back of the envelope calculation. We need precise maturity date of GER and US bonds, precise pricing of the bonds, etc. all taken simultaneously. Consider bid ask spread. All we can say is they are close, US may be better choice now from this quick calc. $\endgroup$ – Alex C Sep 19 '19 at 16:29
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    $\begingroup$ Thanks, if the obtained yield is higher than the 2Y t bonds as they say in the article, does it mean it's an arbitrage situation ? Edit : sorry i deleted my first comment while you were answering $\endgroup$ – TmSmth Sep 19 '19 at 16:34
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    $\begingroup$ This description is for hedging the purchase of a zero coupon bond. To be fully hedged, one would need to sell the EUR coupons forward, as well as the face value of the bond. Also, the dirty price of the bond is the amount of EUR that need to be purchased. $\endgroup$ – AlRacoon Sep 20 '19 at 1:04
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    $\begingroup$ Agreed, it is a simplified answer in that it does not take into account those things you mention. $\endgroup$ – Alex C Sep 20 '19 at 1:29

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