Interest Rate Arbitrage
Interest rates have an effect on the bond market, and to a lesser extent, the stock market. Foreign interest rates can have a positive or negative impact on foreign bonds or other assets as well. Not commonly known is that it is possible to profit from the difference in interest rates between countries.
Interest rates vary between countries based on their current economic cycle, which creates an opportunity for investors. By purchasing foreign currency with a domestic currency, investors can profit from the difference between the interest rates of two countries.
Arbitrage in investments refers to an investing strategy that capitalizes on market inefficiencies to trade nearly risk-free. This arbitrage strategy has become commonplace, with the near-instantaneous transaction abilities of the technological trader.
Covered Interest Arbitrage
The most common type of interest rate arbitrage is called covered interest rate arbitrage, which occurs when the exchange rate risk is hedged with a forward contract. Since a sharp movement in the foreign exchange (forex) market could erase any gains made through the difference in exchange rates, investors agree to a set currency exchange rate in the future in order to erase that risk.
For example, suppose that the U.S. dollar (USD) deposit interest rate is 1%, while Australia's (AUD) rate is closer to 3.5%, with a 1.5000 USD/AUD exchange rate. Investing $100,000 USD domestically at 1% for a year would result in a future value of $101,000. However, exchanging USD for AUD and investing in Australia would result in a future value of $103,500.
Using forward contracts, investors can also hedge the exchange rate risk by locking in a future exchange rate. Suppose that a 1-year forward contract for USD/AUD would be 1.4800—a slight premium in the market. The exchange back to dollars would, therefore, result in a $1,334 loss on the exchange rate, which still yields an overall $2,169 gain on the position and offers downside protection (when the market turns down).
Carry Trade & Other Forms of Arbitrage
The carry trade is a form of interest rate arbitrage that involves borrowing capital from a country with low-interest rates and lending it in a country with high-interest rates. These trades can be either covered or uncovered in nature and have been blamed for significant currency movements in one direction or the other as a result, particularly in countries like Japan.
In the past, the Japanese yen has been extensively used for these purposes due to the country's low-interest rates. In fact, by the end of 2007, it was estimated that some $1 trillion was staked on the yen carry trade. Traders would borrow yen and invest in higher-yielding assets, like the U.S. dollar, subprime loans, emerging market debt, and similar asset classes until the collapse.
The key to a carry trade is finding an opportunity where interest rate volatility was greater than the exchange rate's volatility in order to reduce the risk of loss and create the "carry." With monetary policy becoming increasingly mature, these opportunities are far and few between in recent years. But, that doesn't mean that there aren't any opportunities.
Risks With Interest Rate Arbitrage
Despite the impeccable logic, interest rate arbitrage isn't without risk. The foreign exchange markets are fraught with risk due to the lack of cohesive regulation and tax agreements. In fact, some economists argue that covered interest rate arbitrage is no longer a profitable business unless transaction costs can be reduced to below-market rates.
Some other potential risks include:
- Differing tax treatment
- Foreign exchange controls
- Supply or demand inelasticity (not able to change)
- Transaction costs
- Slippage during execution (change in the rate at the moment of the transaction)
It's worth noting that most interest rate arbitrage is conducted by large institutional investors that are well-capitalized to profit from small opportunities by using tremendous leverage. These larger investors also have a lot of resources on hand to analyze opportunities, identify potential risks, and quickly exit trades that are turning south for one reason or another.
If you're considering a carry trade, you should be aware of these important risk factors and ensure that you've done your homework. The foreign exchange markets can be extremely volatile and risky, especially when using high amounts of margin and leverage. It's generally a good idea to keep margin levels low and focus on well-researched short-term niche opportunities.