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One technique that some investors use in an effort to meet their financial objectives is interest-rate carry trades. The idea behind this strategy is borrowing at a low interest rate and then lending out at a higher rate in an effort to generate returns.

To break the term interest-rate carry trade down one step at a time, the carry of an asset is the return associated with holding that asset.[1] In the event that this return is negative, the carry is the cost that stems from retaining that particular asset.

An interest rate is the cost of borrowing money. It also represents the benefit that an investor or financial institution receives for being willing to lend money.

What Are Interest-Rate Carry Trades?

Interest-rate carry trades are a form of arbitrage, in which someone makes use of the difference that exists between two markets in order to turn a profit. Theoretically, a cup of coffee should cost the same whether it is in the U.S., Brazil or Japan. However, this is frequently not the case, and such disparities can provide opportunities for investors.

Traders evaluating such possibilities should keep in mind that a wide range of factors could result in their transactions creating losses. For example, if prices in different markets fluctuate unexpectedly, such a development could hinder one's efforts to turn a profit. Another event that could either lower or eliminate returns is a change in foreign exchange rates. Losses can sometimes exceed deposited funds.

Interest-Rate Arbitrage

A simple example of how market participants can take advantage of market arbitrage is differences in interest rates. For example, financial institutions can borrow money from depositors at low interest rates and then in turn lend these funds out to borrowers at higher rates. By borrowing at the low overnight rate and then lending at the long-term rate, these organisations can profit from the interest-rate differential.

For example, observers have stated that in the 1950, 1960s and 1970s, banks would pay depositors 3% for their funds and then lend out at 6%.[2] As a result, these financial institutions were able to obtain a 3% spread on the money they took in from depositors. Many have cited weak competition and lax regulation as helping make this kind of spread possible, and they have emphasized that the landscape has changed substantially since then.

Yield Curve And Returns

It is worth noting that borrowing at a short-term rate and lending at a long-term rate generally produces returns with an upward-sloping yield curve, which exists when bond yields increase as bond maturities rise.[3] The idea behind this relationship between yields and maturities is that as investors spend more time waiting to get their money back, they must be compensated for incurring this form of risk.

Should the yield curve become downward-sloping, meaning that short-term bonds pay higher yields than those with longer maturities, borrowing at short-term rates and then lending out at long-term rates could quickly generate a loss.

There are other risks. For example, if a retail or institutional investor borrows at short-term rates and uses the resulting funds to enter a long-term position that produces a higher interest rate, the plan could backfire in several ways. If the short-term rate climbs suddenly, this development could cause the interest-rate carry trade to produce a loss. The same result could happen if the investor enters an interest-bearing, long-term position and that position defaults.

Interest Rate Determinants

Investors considering interest-rate carry trades may benefit from studying the determinants of interest rates.

Supply And Demand: At the most basic level, interest rates are based on the supply of and demand for capital.

If a high number of market participants are seeking finances for purposes such as funding business ventures, buying houses and purchasing automobiles, the demand for capital will be high. However, if these borrowers are reluctant to acquire such financing, demand for capital will be low.

The supply of capital hinges on how much funding financial institutions and investors are willing to offer would-be borrowers. Both the desire of borrowers to obtain money and the willingness of lenders to loan out financing can shift very quickly, so investors interested in interest-rate carry trades may monitor these developments regularly to be prepared.

Central Bank Policy: Another major factor that can affect interest rates is central bank policy. Generally, if a nation's central bank hikes its benchmark rates, this move will place upward pressure on broader interest rates. Likewise, if the same central bank cuts its benchmark rates, this development will generally push overall borrowing costs lower.

Inflation: Another major factor that can affect interest rates is inflation. If inflation rises, this development could place upward pressure on interest rates. If the price level increases, lenders will likely want to charge a higher rate to compensate for the decreased purchasing power of the original principal they lent out.

Summary

While some investors harness interest-rate carry trades in an attempt to generate returns, interest rates can shift substantially in a short period, resulting in reduced returns or losses. Traders interested in such strategies should be sure to research the matter in-depth and/or consult an independent financial adviser before entering any positions.

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