Arbitrage

Until a few weeks ago I had no idea what arbitrage was or even how useful it could be. Wikipedia's definition of arbitrage is: In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: a combination of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices.

Essentially the idea is to borrow money with a low, or in some cases, zero interest rate, invest that money into something which will earn a reasonably high rate of return for the term of the loan, and then repay the loan at the end of term, pocketing the interest earned on borrowed money.

Both Million Dollar Journey and Loonies and Sense have posted on this topic as it relates to using credit cards. Interesting concept, but as they point out, often hard to do in Canada because we get fewer no interest credit card offers than in the US. I recently was pre-approved for a university alumnus card though with 1.99% interest rate for 10 months, but I am going to use this to leverage interest savings from my higher interest loans.

A friend of mine first told me about arbitrage. She had been to her financial planner who recommeneded the following, which I will use an example of how arbitrage can increase your savings.
1. Take out a loan against the equity of your home, ensuring the loan only requires interest (not principal) payments. The loan in her case would be for $40,000, at 6% interest.
2. Invest the $40 k in investments which would make about 8%. If possible, invest so you can also realize some tax benefits (like the Smith Maneouvre).
3. Make the monthly interest payments, which in this case, would be $200.
4. Every year, claim any interest allowed on your tax return.
5. Maintain the investment for 10 years.
6. All going well, at the end of the 10 years the $40k will have grown to $88,786. The $40,000 loan is repaid, and $48,786 gets put in to your pocket (or other investments!).

Compare this to contributing $200 for the same time period, 10 years, with no initial investment. At the end, you would only have $36,025 saved. So the power of arbitrage is that you can leverage borrowed money, which earns you more interest quickly, and can increase your investment substantially (by $12k in this case).

Arbitrage must really take guts though. There is now way we can do it right now, but I am glad I learned about it. I am not sure if I will have the fortitude to try it in the future, but perhaps if we were more financially stable, I would be able to take risks such as this.

3 Comments:

  1. Frog of Finance said...
    I recently started an experiment regarding credit card arbitrage, and just posted an update on it today.

    http://frogoffinance.blogspot.com/

    Cheers!
    SheGazelle said...
    On the surface, your example looks like you would clear 2% on your money. Unfortunately, one variable that is often left out of these calculations is RISK. My opinion is I'd rather not risk my house for a mere 2%.
    Great topic you've addressed here!
    Jerry said...
    Prime is 6.25%
    If you have a GUARANTEED 8% annual return, do let us know :)
    Otherwise, mere 1~2% for 1~2 years, and a hit on the credit score is not worth it IMO

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