Credit costs involved in setting up the trade
credit costs
At inception the two legs of the trade have the same PV01 expressed in base currency while the two market values may differ. Yet, this difference is limited when pairs of bonds with similar durations are selected. The trade is equivalent to a view on the difference in Libor spread between a pair of bonds in two currencies. That view has to be strong enough to compensate for a hurdle rate made up by the sum of the following terms:
credit costs
- costs of the asset swaps,
- costs of the currency hedge,
- credit costs involved in setting up and unwinding the trade.
It seems that this approach is likely to represent a trading opportunity that can be exploited profitably. An unpublished study by Desclée and Rosten (2003) without and with transaction costs indicates positive information ratios for trading strategies where investors go long a particular issuer in the currency where its spread is highest and short it where its spread is lowest.
In an unfunded strategy, however, transaction costs and financing considerations must be taken into account. Furthermore, the performance of the strategy has varied substantially over time. In general, the number of trading opportunities has improved steadily since 2000 due to the broadened universe of truly global issuers, with multiple securities outstanding in various markets. High spread levels and spread volatility tend to raise the potential for implementing the strategy. Especially investors that are benchmarked relative to a global credit index may benefit from frequent trading opportunities.
