Tuesday, June 14, 2011

Interest rate arbitrage explained

So ehow has a pretty short and concise guide to interest rate arbitrage.

Basic run down: You get a loan somewhere, then invest it into a higher yielding instrument and make a profit on the difference. If the financing and investments are of different currency origins, then you'd need to hedge the exchange rate risk via derivatives e.g. FX futures and/or options.

So it takes a bit of legwork, but doable in theory. If most of the folks in your area are clueless around this, then your local financial market may still be inefficient enough to have this opportunity available.

Here's the ehow guide for Americans:
    •  First you need to find a bank that either offers an unsecured loan (if your credit is good) or a CD secured loan (if your credit score has some room for improvement). This works even better if you have a friend who is willing to front you some money.
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      The bank you choose should also have some type of deposit special going on as well. You can search for "high yield savings or checking accounts". Most banks and credit unions have something, but you can also check out "Rewards Checking" because that is a really high interest rate. If you are borrowing from a friend or family member, let them know you will give them a little extra. You can give them a set dollar amount like 3 months interest on a 6 month CD.
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      Deposit the money into a CD. Typically, you can expect to earn between 1% and 1 ½ % on a 6 month CD, at the time of this article's writing. Next, take out a secured loan on the CD, the rate of which will vary, but will usually be in the neighborhood of one full percentage point above the rate you are earning on the CD. So, if you are making 1.2% on the CD, expect to pay 3% on the loan (one FULL percentage point). Now, either the bank you are at, or another bank or credit union should be running some type of special. The banks that have the Rewards product (see Resources) average between 2% and 5%. From here on the math is simple. You are paying 3% on your loan, your principal investment in the CD is still accruing interest, and you deposit the proceeds of your loan in to the checking account making, say 5%. You win, even if you give some of the interest to the person you borrowed the money from.


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