Carry and Relative Value Trades
In Chapter 6 we considered the process of taking views on where interest rates or curves may be headed. For such trades, the aim is to take a view on the level and shape of the yield curve. In certain regimes, such as when the Fed is firmly on hold, rates and curves may be rangebound for long periods of time. This chapter considers trades ideal for such environments: carry trades and relative value trades. It may seem at first glance that trading involves mostly taking directional bets on interest rates. However, carry trades and relative value trades are important classes of trades where the main motivation is not to take an outright view on the market. Instead, the aim is to initiate trades that either generate net income from holding interest rate securities or take advantage of dislocations in markets. Carry and relative value trades have distinct methods to earn profits, but have many similar underlying principles. They are essential concepts to understand not just to profit from rangebound markets but also to express views on interest rate markets more effectively in any environment.
The chief aim of a carry trade is to earn income from holding an asset. Chapter 2's introduction to bonds showed that carry is calculated as the coupon income of a bond less the financing cost. The term “carry trade” is more general than just the carry from buying a bond, but at their core, carry trades tend to optimize net income from holding ...