What is Interest Rate Arbitrage?
Interest rates impact both the stock and bond markets. Investors in India have access to global options to take advantage of different interest rates. Foreign bonds and other assets are affected positively or negatively by foreign interest rates. Interestingly, it is possible to profit from the difference in interest rates between countries.
Again, interest rates are different in different countries based on their current economic cycle. Investors purchase foreign currency with a domestic currency, and they benefit from the difference in interest rates between the countries.
Hence, arbitrage in investments is supposedly an investment strategy that leverages on market inefficiencies to trade nearly risk-free. This strategy has become prevalent, thanks to the almost-instant transaction abilities of the technological trader.
Covered Interest Arbitrage
This is the most usual kind of interest rate arbitrage. This kind of interest rate arbitrage occurs when the exchange rate risk is hedged with a forward contract. A sharp movement in the foreign exchange (forex) market could take away any gains obtained through the exchange rate difference. Hence, investors agree to a set currency exchange rate in the future to mitigate that risk.
Investors could also hedge the exchange rate risk, using forward contracts, by locking in a future exchange rate.
Other Forms of Interest Rate Arbitrage
Carry Trade is yet another 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 open or secretive, and it is believed to result in significant currency movements in one or the other direction.
In the case of a carry trade, it’s essential to find an opportunity where interest rate volatility is greater than the exchange rate’s volatility. This is used to reduce the risk of loss and create the “carry.” As monetary policy became increasingly mature, these opportunities became rare. But some opportunities still exist.
Risks with Interest Rate Arbitrage
Interest rate arbitrage is not without any risk. The foreign exchange markets are full of risks owing to the lack of proper regulation and tax agreements. Covered interest rate arbitrage is no longer considered a profitable business unless transaction costs could be reduced to below-market rates. There are some other probable risks involved, such as foreign exchange controls, differing tax treatment, supply or demand inelasticity, transaction costs, slippage during execution.
It’s important to note that most interest rate arbitrage is carried on by large institutional investors who are well-equipped to benefit from small opportunities by using huge leverages. These large investors also happen to have a lot of resources in hand to see through options and analyse those. They also then identify potential risks and quickly exit trades that are turning in the opposite direction due to some reason.
The foreign exchange markets can be extremely volatile and risky. This is truer when you have more at stake like a high margin. So, it’s advisable to keep margins low and keep the focus on well-researched, short-term niche opportunities.
Though interest arbitrage sounds complex, if you want to go for it, it’s imperative to do your research. You must look into the political, economic and social elements of the markets in which you want to do arbitrage. Only then you are likely to benefit from this.