If you have tried to open a savings account you might have had the frustration of finding out that the local branch of your Wells Fargo is only offering a 0.1% interest rate.
These so-called “zombie” accounts aren’t the best, and millions of savers often find themselves stuck with rotten rates.
Interest Rates Aren’t Born Equal
It’s a wide world on the web, and in your internet research you get sucked into a little bit of a black hole only to come across a bank in the U.K. offering 5.3% interest. You think to yourself, “Wow, if only I could get that deal.”
Your mind starts to race as your full-proof financial plan starts to take form in your brain. I’ll move the money across the pond and collect 5.3% on my money. Easy game!
A flash of inspiration; you quickly check the interest rate on a loan in the U.S.
Amazing! Your plan changes again. You’ll borrow the money at 2.8%, collect interest at 5.3%, pay the difference and sit back while the money rolls in. Right?
Sigh…that would be nice. Except if it were that easy – everybody would be doing it.
What is Arbitrage?
The above example highlights the economic principle of arbitrage. In economics, arbitrage happens when an investor takes advantage of a price difference between two or more markets and by doing so, earns a risk-free profit.
For example, let’s say you are looking for a water filtration system for your home. You find that the market rate in the states is about $1200 for a high-end purification system. However, you know that you can get the same item for a third of the price in China. You can take advantage of that arbitrage situation by buying low in China and then selling high in the U.S., profiting from the price differential.
Actors in the financial world engage in the arbitrage all the time. Banks and brokerage firms are always on the lookout for potential arbitrage situations.
Coming back to our interest rate example, in a perfect world you’d sit back and the money would flow in, and while the U.K. bank’s interest rate of 5.3% sounds amazing compared to the paltry 0.1% earned in a U.S. bank account the truth of the matter is that things are just more complicated than that.
What About Inflation?
In the real world, we have to consider the inflation and exchange rate. The effects of these two combine to wipe out any chance you would have of capitalizing on the interest rate differentials.
When we look at two countries, the economic principle of interest rate parity tells us that you can expect the return on foreign currency assets to equal the return on domestic assets.
If the U.K. interest rate is 5.2% higher than the U.S. rate then we can infer that the British pound is expected to depreciate by that much over the next year.
In the last few years the U.S. interest rate has been very low, but at the same time the U.S. dollar has appreciated against other currencies and we live in a strong dollar world.
Let’s imagine that at the beginning of this year, January 1st 2015, you move $1000 to England to try and take advantage of their higher interest rates. The exchange rate is 1.52 USD/GBP and you invest ₤658 ($1000/1.52) at an interest rate of 5.3%.
At the end of the year, your money has grown and now you have ₤693. You convert your money back to dollars and expect to do a little jig when you see the final numbers.
Remember how the British pound was expected to depreciate? Well it did and now the exchange rate is only 1.44 USD/GDP.
You don’t do any jigs. You’re $1000 is now only worth $998 after a year!
In the end you would have been better off investing your $1000 in a U.S. bank account earning 0.1%, because than you would have at least made $1 instead of losing $2.
Throw in taxes and transaction costs (every time you convert the money you could incur costs) and now you’ve lost way more than you ever thought you would have.
Arbitrage in the Real World
It’s not that arbitrage is impossible. As stated earlier, banks and other financial institutions are always on the lookout for potential situations to profit from, but they have an army and are well poised to take advantage of such situations. Often, these arbitrage situations occur in the short-term, minutes and hours and days rather than over a year like in the example described above. Banks wield large sums of capital so as to fully exploit price differentials, even very minute ones.
It’s not impossible, but it can be risky. Arbitrageurs, have to look out for execution risk. Imagine you spot an error where Google is trading at $300/share on NYSE and $320/share on the London Stock Exchange. You buy up a thousand shares, hoping to make $20 on each one but then find that no one is buying on the LSE. You’re now stuck with a big position and tons of risk.
Sometimes even the big players don’t do it right. Long-Term Capital Management (LTCM) lost over $4 billion in 1998 attempting fixed income arbitrage. Fixed income arbitrage involves bonds so for example LTCM would sell U.S. Treasuries and buy Spanish bond futures. The differences were tiny so a large amount of money had to be deployed to make this strategy profitable, but they misunderstood just how much risk they were putting themselves in.
The bottom line is this. There are people who can benefit from short-term fluctuations in interest rates, but they are generally institutional players. The rest of us, we have to take what we can get.
To learn more, head over to Wall Street Survivor.