Interest Rate Arbitrage

Many Hedge funds and institutional investors engage in the foreign exchange markets to find additional yield. Countries, such as Australia and New Zealand, which have high interest rates, attract funds from lower interest rate countries, such as Japan and the United States. Sophisticated international investors move money between currencies, just as more conventional investors move money between different bond issues.

In interest rate arbitrage, a trader borrows (and pays interest on) a currency with a lower interest rate, and uses it to buy a currency with a higher interest rate (the "carry" currency) in order to capture the difference between the two interest rates.

The interest rate arbitrageur's strategy is to buy and hold the carry currency for an extended period of time, in order to profit from the difference in interest rates offered by the two currencies.

As in all financial transactions there is risk involved. For instance, an arbitrageur may borrow a million Japanese yen, which carries an interest rate of near 0.0%, in order to exchange it for 80,000 New Zealand dollars (depending on the prevailing exchange rate) which offers an interest rate of 7.75%. As long as he holds the NZD, the trader profits from the interest rate difference between the two. But as long as he holds the position, he is also vulnerable to a change in exchange rates.

If the NZD appreciates vs. the yen, the profit is even greater, since the trader would own more potential yen with the same amount of NZD. Should the NZD depreciate against the yen, however, the trader could register a loss, which could potentially consume part of or more than the interest rate profit.

Central Bank Interest Rates*
New Zealand Dollar	7.75%
Great Britain Pound	5.50%
Canadian Dollar	4.25%
Swiss Franc	2.25%
Australian Dollar	6.25%
US Dollar	5.25%
Euro	3.75%
Japanese Yen	0.50%