X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2018 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
A Free Lunch? - Outside View
  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

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!

Disclaimer:
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.

Equitymaster requests your view! Post a comment on "A Free Lunch?". Click here!

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

Like 
  
Equitymaster requests your view! Post a comment on "A Free Lunch?". Click here!

More Views on News

Insider Leaks Equitymaster Stock Picks (The 5 Minute Wrapup)

Jul 25, 2017

Equitymaster HQ has been infiltrated. Valuable stock ideas have been leaked. Who's responsible?

Raymond and Other 'For Profit' Companies Who Don't Care about Shareholder Returns (The 5 Minute Wrapup)

May 27, 2017

What happens when minority shareholders are short-changed in the normal course of business?

Why Commission Driven Model In Mutual Funds Should Be Eliminated... (Outside View)

Feb 15, 2017

PersonalFN believes SEBI has taken a step back-apparently in the admission of it going overboard with the regulations.

This Book Changed How I Looked at the World of Man and Money (Vivek Kaul's Diary)

Aug 24, 2016

And here's your chance to claim a free copy of this book...

The Developed World is Dying because of Demographics, Debt, and Deflation (Vivek Kaul's Diary)

Aug 12, 2016

And Why India's demographic dividend could turn out to be a doubtful debt...

More Views on News

Most Popular

Here's What You Should Do in this Market Crash(The 5 Minute Wrapup)

Feb 6, 2018

The market correction has provided a golden opportunity to buy five high-quality safe stocks.

As the Market Corrects... It's Time to Buy More(Smart Contrarian)

Feb 5, 2018

The recent sell off in the stock market offers buying opportunity in some quality small caps.

The Era of Easy Money is Coming to an End. What Happens Now?(Vivek Kaul's Diary)

Feb 9, 2018

The easy money policy of the Federal Reserve of the United States, which drove up stock markets all over the world, is ending, with the Federal Reserve looking to shrink its balance sheet.

When Small is Not Always Beautiful(Chart Of The Day)

Feb 6, 2018

Big companies enjoying tax deductions and exemptions have an edge over the small companies.

What Should Mutual Fund Investors Do After LTCG Tax Norms(Outside View)

Feb 6, 2018

PersonalFN explain what investors should after LTCG tax norms.

More

Small Investments
BIG Returns

Zero To Millions Guide 2018
Get our special report, Zero To Millions
(2018 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

MARKET STATS