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A Free Lunch? - Outside View

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A Free Lunch?
Jul 12, 2010

If I walked into a bank today and asked them for a loan to buy a house, they might charge me an interest rate of 5%. If I walked into that same bank and instead asked for a savings account, they would for example, pay me an interest rate of 2%. So the bank can acquire funds at a cost of 2%, and lend those same funds at a rate of 5%, making an interest rate spread of 3%. This is, in a nutshell, how banks make money.

Now imagine you could do the same, that is: borrow money at a low interest rate, and then deposit that same money at a higher interest, earning yourself a handsome spread and profit. Does it sound too good to be true? Well, you might have heard the saying, 'There is no free lunch'. This is akin to saying that one cannot earn a riskless profit. In the example of the bank in the first paragraph, when the bank lends me money to buy a home at 5% interest, there is always the risk that I will default on my repayment and the bank will lose its money.

Let's start with some statistics:

(GBPJPY - Japanese Yen per British Pound)

(The interest rates are the central bank overnight rates)

  Jun-02 Jun-07 Jun-10
GBPJPY 182 247 134
Britain's Interest Rate 4% 5.50% 0.50%
Japan's Interest Rate 0.10% 0% 0.10%
S&P 500 990 1503 1031

GBPJPY gained an impressive 35% from June 2002 - June 2007, all while British interest rates commanded a significant premium over corresponding Japanese rates, and stock markets were booming. In the last three years, British interest rates have fallen to the point where the interest rate differential between the two countries is now negligible. At the same time, GBPJPY has fallen a staggering 46% and stocks are close to their initial 2002 level.

What is going on here? Why did the pound rise so much and then fall so drastically? Surely the differences between the economies of Japan and Britain are not enough to explain such movements. The answer to this question is: The Carry Trade. Remember I asked the question as to whether you could borrow at a low rate and then invest at a higher rate? Well, this is exactly what is going on, except that we use two different currencies.

The carry trade is when an investor borrows money using a low yielding currency, and then invests it in a higher yielding one. In June 2002, you could have borrowed yen, sold it in exchange for pounds, and then invested the pounds to earn a higher interest rate than you need to pay for the borrowed yen. I'll repeat what I said earlier that 'There is no free lunch'. This strategy is certainly not risk free because the exchange rate can move from when the initial transaction takes place.

Though it is a risky strategy, it was, and remains a popular one. As stock markets rose from June 2002 - June 2007, investors continued to sell yen to buy higher yielding currencies (like the pound). Consequently, the yen fell over that period. Over the last three years as the global financial crisis hit, we have witnessed a massive unwinding of the carry trade - that is people selling their higher yielding currencies and converting it back to yen. I'm sure you can imagine that understanding the carry trade can provide numerous profitable trading opportunities.

During the time the pound fell drastically against the yen, Britain was also experiencing a housing bubble that subsequently burst. In the run up to the bubble, banks were offering a particularly innovative type of mortgage, which allowed the homeowner to borrow funds in the currency of their choice. People naturally chose to borrow in yen, as the interest rates were the lowest among the G8. The yen would be converted to pounds to buy the house, and the homeowner would make monthly repayments in pounds that would be converted back to yen. The repayments were quoted in yen. If you took out this mortgage in June 2007, can you imagine what happened three years later? Due to the collapse of the pound, the debt repayments (in pounds) would now be almost double what they started out as. To top it off, the homeowner would be thrown into severe negative equity. I'll say it for the last time, 'There is no free lunch'.

This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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1 Responses to "A Free Lunch?"

vinay kumari

Jul 21, 2010

A very smart way to make an ordinary person to undestand the money-making technique of banks

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