Interest rates affect the bond market and, to a lesser extent, the stock market. Foreign interest rates can also have a positive or negative impact on foreign bonds or other assets. It is not widely known that it is possible to profit from the difference in interest rates between countries.
Covered Interest Rate Control
The most common type of interest rate control is known as covered interest rate control, which occurs when exchange rate risk is hedged through a futures contract. Since sharp movements in the foreign exchange market can wipe out any gains made from the interest rate differential, investors agree on a specified future exchange rate to eliminate that risk.
For example, suppose the interest rate on a U.S. dollar (USD) deposit is 1%, while the interest rate in Australia (AUD) approaches 3.5%, with an exchange rate of 1.5000 USD/AUD. Investing $100,000 locally at 1% for one year would yield a future value of $101,000. However, converting USD to AUD and investing in Australia would yield a future value of $103,500.
Using futures contracts, investors can also hedge exchange rate risk by securing a future exchange rate. Suppose a one-year futures contract for USD/AUD is 1.4800 – a slightly high value in the market. The resulting conversion back to dollars would lead to a loss of $1,334 on the exchange rate, which still realizes a gain of $2,169 on the position and provides downside protection (when the market is heading down).
Carry Trade and Other Forms of Interest Rate Control
Carry trade is a form of interest rate control involving borrowing capital from a country with low interest rates and lending it in a country with high interest rates. These trades can be hedged or unhedged in nature and have been blamed for large currency movements in one direction or another as a result, especially in countries like Japan.
In the past, the Japanese yen was widely used for these purposes due to the low-interest rates in the country. In fact, it was estimated that about $1 trillion was borrowed in yen carry trade by the end of 2007. Traders were borrowing yen and investing in higher-yielding assets, such as the U.S. dollar, high-yield mortgage loans, emerging market debt, and similar asset classes until the collapse.
The key to carry trading is finding an opportunity where interest rate volatility is greater than exchange rate volatility to reduce the risk of loss and create a “carry.” As monetary policy has matured, these opportunities have become scarce in recent years. But that doesn’t mean there are no opportunities at all.
Risks of Interest Rate Control
Despite the shining logic, interest rate control is not without risks. Foreign exchange markets are filled with risk due to a lack of cohesive regulation and tax agreements. In fact, some economists say that covered interest rate control is no longer a profitable endeavor unless transaction costs are reduced below market rates.
Some potential risks include:
- Different tax treatments
- Foreign exchange controls
- Inflexibility of supply or demand (unable to change)
- Transaction costs
- Slippage during execution (price change at the moment of transaction)
It is important to note that most interest rate control is done by large institutional investors who have substantial capital to take advantage of small opportunities using massive leverage. These larger investors have many resources available to analyze opportunities, identify potential risks, and quickly exit trades that go south for one reason or another.
If
You were thinking about campaign trading, and you should be aware of these important risk factors and ensure that you have done your homework. The foreign exchange markets can be extremely volatile and risky, especially when using large amounts of margin and leverage. Generally, it is good to keep margin levels low and focus on specialized short-term opportunities that are carefully considered.
Source: https://www.thebalancemoney.com/what-is-interest-rate-arbitrage-1978928
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