Interest rate arbitrage

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: Contrary to the assumption most investors harbour that arbitrage means buying cheap and selling high, it is, in precise terms, leveraging on the difference between the price or the value of a security in two markets.

Considering that ‘interest rate’ has become the buzzword of the markets, ‘Interest Rate Arbitrage’ (IRB) would be one of the potent tools used by HNIs and FIIs alike, to milk the interest rate difference between the US (3.25%) and emerging markets like India (7%). Hence, it is of immense importance to understand what it entails.

In sum

IRB is the simultaneous exploitation of interest rate differentials in one or more markets for profit. Arbitrageurs may either transfer their own capital from one market to another or simultaneously borrow in one market and lend in another.

Interest rate arbitrage is based upon the principle of interest rate parity, which is expressed by: the difference in interest rates = difference between spot and forward rates of exchange: (f0 - s0)/s0 = (ix - iy)/(1 + iy), where f0 is the forward rate of exchange of the foreign currency against the home currency; s0 is the spot rate of exchange between the two currencies; ix is the interest rate on the foreign currency; and iy is the interest rate on the home currency. An important point to note in an interest rate arbitrage is the re-conversion element. Suppose one borrows money in dollars at an interest rate of say 3.25%.

Now you lend that money by converting it into Indian rupees. Now, after reconverting, the money earned on lending depends upon the dollar-rupee denomination and interest rates (between the two countries) convertible difference. The larger the difference, the possibility of earnings may be higher.