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Digital Subscriptions > The Hedge Fund Journal > Issue 126 - September 2017 > Interest Rate Arbitrage in Negative Yielding Currencies

Interest Rate Arbitrage in Negative Yielding Currencies

Arbitrage example using Swiss Franc options

In a world of negative interest rates and growing risk for asset price bubbles everyone is seeking new high yield/low risk opportunities. One might be based on the weird situation that banks pay deposit rates which are above the inter-bank lending rates. This offers a possibility of arbitrage in CHF and EUR especially for wealthy private investors with a sizeable bond or equity portfolio.

1. Idea

The idea is very simple. Get a loan with negative interest rates, use your bond or equity portfolio as collateral and deposit the capital that you get from the loan for an interest rate of zero. The result is that you’ll get interest for the loan (because of the negative interest rates) and you’ll get and pay nothing for the deposit. Ideally you even receive interest on your deposit and you can leverage this deal 10+ times and you will earn a high return with a low risk profile, but let’s see how the trade works.

2. Implementation

a) Taking up a loan with negative interest rate

The main question that I asked myself at the beginning of the construction of this arbitrage deal was: how to get a loan with a negative interest rate as a normal retail customer. Based on my experience as a derivatives trader I finally came up with the idea to use a “box”. A box trade is a combination of European style options which are combined in a way that they deliver a zero coupon bond return. That means that the only price risk that remains is an interest rate risk. Delta, Gamma and Vega are zero and only Theta and Rho remain. If the box is traded as a short box then it works like the issuance of a zero coupon bond (equivalent to taking up a loan with fixed interest rate and one bullet payment at maturity). A “short box” consists of a sale of one in the money call and one in the money put and the purchase of one out of the money call and one out of the money put. The short call and long put have the same (low) strike and the short put and the long call have the same (high) strike (see example below). As a result, by selling a box you receive cash. The amount of cash equals the difference of the two strikes times the option multiplier (“nominal amount”; multiplier e.g. 10 for Eurex EuroStoxx 50 or SMI Index Options) less the interest value of the option. This equals exactly a zero bond, which is traded at its nominal less a discount for interest. As the interest rate that is incurred in the pricing of a box is negative the price of the box is higher than its nominal amount. That means by selling a box you receive the nominal amount plus interest and you only have to pay back the nominal amount. So finally by selling a box you effectively take up a loan with a negative interest rate which leads to the fact that you have to repay less than you receive initially. That’s how negative interest rates work.

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