Break even Spread analysis

[Kirtika]

Hi All,
I suppose that yield advantage of investing in the foreign country can vanish if the yields in domestic markets increase or the foreign yields decline.As per example 20 CFAI currilculum pg 254 Volume 4 .It says spread widening and falling yields in the domestic currency makes foreign bond investment futile. Can someone please explain….

 

[hiteshsavanth]

Kirtika wrote:
I suppose that yield advantage of investing in the foreign country can vanish if the yields in domestic markets increase or the foreign yields decline.

Hey, i think you might have mixed that up! I don’t have the CFAI text in front of me, but i just read up this part last night and here is my take on it:
Spread advantage of holding the foreign bond = Foriegn yield-Domestic yield.
Spread can widen either by increase in foreign yield OR decrease in domestic yield.
Foreign yield goes up –> Foreign bond prices fall –> Advantage of holding foreign bond is lost on a total return basis –> better to hold a domestic bond.
Domestic yield goes down –> Domestic bond prices rises –> Advantage of holding domestic bond as domestic bond prices rise –> better to hold a domestic bond.
Therefore if spread widens, foreign bond advantage is lost.

 

[derswap07]

hitesh,
Very nicely written explanation. Thanks. Can you provide rationale for the formula we use to calculate break even spread please?
Thanks