From Naked Arbitrage To Emerging Markets Crisis

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From Naked Arbitrage To Emerging Markets Crisis

One of the most important concepts in modern finance – and one that I always insist my students master – is that of arbitrage. Unlike speculators (or investors) who seek risks for the sake of netting a profit, arbitrageurs don’t take any risks for the same sake. They exploit differences in prices for similar financial products and open opposing positions whenever they find a profit opportunity, selling at the higher price while buying at the lower one. An arbitrageur doesn’t incur any risk, as the two opposing positions offset each other’s risk. At the same time, this behaviour helps the two prices converge. In this sense the arbitrageur is one of the most important market participants, as he assures that at any point in time, the same products should trade at the same price, which is the well-known law of one price.

In a rational and efficient market, any pure arbitrage opportunities should not exist, or at least they should not last. With the advent of computers, broadband internet connections, and quick and easy access to financial markets, there is always a battalion of professional traders and a squad of fancy computers equipped with state-of-the-art software seeking for infinitesimal opportunities and prepared to take advantage of them in nanoseconds. In such a world, you, my students, and I would never have the slimmest chance of making a living out of pure arbitrage opportunities. That is a fact that modern finance takes as a premise. It is exactly because arbitrage opportunities are so scarce and short-lived that when pricing derivative contracts and many financial instruments, we implicitly assume that there are no arbitrage opportunities. Just look at how futures, options, forward contracts and other instruments are priced. When pricing them, we always depart from the idea that the rational and efficient price is the one at which there is no way someone can jump into the market and reap a risk-free profit out of it.

But while modern finance assumes that arbitrage opportunities are so limited that one can take them as non-existent, the real business world seems to disagree, as professionals often jump into markets seeking for what they think are real risk-free advantages.

Exploring the arbitrage opportunity

One of the most common arbitrage deals occurs within the interest rate world. Under the modern day framework of free global capital flows where each country holds its own currency and monetary policy, there is a plethora of different interest rates at which one can borrow and lend. Therefore, with the policy rate now standing at 12.75% in Brazil while being held at 0.50% in the UK, there is a huge incentive for a Brazilian company to borrow in GBP instead of borrowing in its domestic currency, the Brazilian Real (BRL). So, let’s say a hypothetical company GasBras (hope there’s none with this name!), needs BRL 40 million to develop a new gas exploration project. Instead of borrowing the funds at a rate of around 12.75% in the Brazilian market, the company’s finance director decides to tap the British market and borrow an equivalent amount in GBP for a rate around 0.5%. At the current spot GBP/BRL rate of 4.7650 he asks for £8.4 million GBP, pays 0.5% in interest and then repays the loan in 1 year. That’s smart! Instead of paying BRL 5.1 million in interest to a Brazilian bank, GasBras would pay £42,000 to a British bank, which at the current spot rate translates to BRL 200,130. That’s just a tiny fraction of what it would have to pay if borrowing in BRL.

GasBras then takes advantage of the interest rate differential between the two countries to lock in a 12.25% difference. But rather than outsmarting the market with an arbitrage strategy, the company is just speculating in currency values. There is no assurance the foreign exchange will wait for GasBras to repay its loan before moving unfavourably. If the BRL loses ground and depreciates 50% to be traded against the GBP at 7.1475 in one year’s time, then GasBras will need around BRL 60 million to repay the loan. The 50% loss via currency depreciation would make GasBras regret its decision to tap the British market instead of sticking with the Brazilian one. At the same time, it clearly shows how far from arbitrage the GasBras strategy was. In fact, a forward contract on GBP/BRL for a 1-year period should be trading around 12.25% higher to reflect the no arbitrage concept. A pure arbitrage opportunity would only arise if the forward GBP/BRL were trading at, let’s say, 5% on the spot price. In that case the company would take advantage of the 12.25% interest rate differential less the 5% loss in the exchange rate, which in the end would make for a profit of 7.75% (in terms of opportunity cost).

Piling debt in U.S. Dollars and Euro

Unfortunately, in the real world there are many GasBras companies, which turn non-existent arbitrage opportunities into real arbitrage opportunities that often end with the company defaulting on the loan terms and eventually being driven to bankruptcy. This situation has been repeated so many times over the years that one can only guess we are heading towards exactly the same once again.

The prolonged ultra low interest rates set by almost all major central banks in the developed world, plus their large-scale asset purchase programmes that turned yields on sovereign debt negative, have been creating an epic encouragement for companies from emerging and frontier markets to issue Eurobonds and take advantage of the rate differential. There is plenty of money available from the US and Europe, desperately seeking investment opportunities. With 10-year sovereign bonds now yielding a negative value in Germany, something greater than zero is a huge profit opportunity for European investors. Joining the yield seeking from advanced countries with the fund-hunger from the emerging world is the explosive recipe that is being cooked.

Piling up euro and dollar denominated debt seems sustainable as long as emerging market currencies keep their strength. With governments of many of these countries having already gone through some kind of deleveraging due to their past excessive debts, it seems there is plenty of room for the private sector now to take the route their governments took in the past. Some of these countries even peg their currencies to the dollar, which further adds to the no-risk profit opportunity case for companies to borrow in foreign currency. Even if depreciation occurs, they believe it would be prevented by the domestic central bank, which would quickly intervene in the market by selling foreign reserves and/or hiking interest rates. But we know how rotten and naive that thinking is, as almost no bank in the world can prevent speculators from driving down the currency, in particular when they believe the country is near bankruptcy. The Bank of England very well knows that, as George Soros (in)famously broke the bank in 1992. But we don’t need to rewind all that much to see examples of this reality. Just look at Russia since mid 2014. The central bank hiked interest rates 650 bps in a single move, after becoming desperate about the route the rouble was taking. Nevertheless, the volatility around the USD/RUB pair has been huge and many companies saw their debt burden quickly rise as the domestic currency plunged.

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A no risk opportunity for emerging markets!?

When interest rates are very low elsewhere and when 10-year sovereign debt yields are negative, the private sector in countries with higher interest rates foresees no risk from borrowing funds in foreign currency. Foreign debt then increases until the point domestic currencies start plunging. That may happen due to a change in monetary policy in the developed world and the hot money flows it encourages, or eventually due to falling prices of commodities that these countries are often dependant on, or simply due to political instability. At that time the debt burden measured in foreign currency goes through the roof and companies start missing interest payments and are unable to rollover the principal. Then comes the IMF lending funds to a bankrupt economy while requiring steep interest rate hikes that will further depress the economy. In the end, domestic governments would be given the burden of repaying the private debt, either directly or indirectly. We have plenty of examples: the Southeast Asia Crisis of 1987, the Mexican Tequila Crisis of 1994, the Russian Crisis of 1998, just to name a few.

The clock is ticking

Just a few days ago, the Bank of International Settlements reported that the outstanding non-bank dollar denominated debt for borrowers outside the US has risen from $6 trillion to $9 trillion since the global financial crisis. That is a 50% increase in a matter of a few years and doesn’t even take into account borrowing in other strong currencies like the euro and the yen. China alone took $1 trillion of it, with Brazil occupying the second position with $300 billion, followed by India with $125 billion. Others include Malaysia, South Africa, Turkey, and some Latin American countries.

The story repeats over and over again but almost no one sees it while those who do pretend they don’t. Central planned monetary policy, when artificially forcing interest rates lower for longer, just creates distortions elsewhere in the world. Under this setting, I can only come to the conclusion that free capital flows are a much-needed mechanism for the developed world. It works as a safety valve assuring the effectiveness of monetary policy without creating inflation.

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