Roland van den Brink: Currency arbitrage, an attractive form of investing

November 5, 2024

Currency

^{This column was originally written in Dutch. This is an English translation.}

By Roland van den Brink, written in a personal capacity

The discussion on efficient markets continues to fascinate. Some large markets still offer interesting opportunities, especially when most players have goals other than making returns.

Equity and bond markets are quite efficient. This is evidenced by the fact that the vast majority of asset managers perform worse than the market index over time. Yet arbitrage does make money. As new information becomes available all the time and supply and demand also changes, there must be parties who keep the market efficient. Exchange traders and banks' trading departments fulfil this important role.

Financial products such as swaps, futures, options and ETFs have increased the need for arbitrage. Profits tend to be modest due to competition and high operating costs. For investors, there are few opportunities to profit from arbitrage other than investing in banks that focus on it.

The foreign exchange market is an exception

However, in the foreign exchange market, the world's largest liquid market, most parties are not concerned with profit maximisation but have other goals:

1. Companies focus on their core business and hedge currency risks;

2. Central banks support their currency to avoid economic turmoil;

3. Travellers often pay attention to travel and accommodation costs, but exchange at unfavourable rates;

4. Institutional investors focus on the intended investment and often see currency as an undesirable risk;

Take Shell, for example: they focus on oil and gas, which are mostly quoted in dollars. Risks of which they have less knowledge are hedged. The company learned a lesson after a billion-dollar loss at their Japanese subsidiary in 1993.

Central banks regularly intervene in the foreign exchange market. In October 2024, India's central bank supported the rupee because of an outflow of foreign investors, increased oil prices and rising interest rates abroad. The central banks of China, Japan, Switzerland and the ECB also regularly take similar actions.

There are other causes that make currency arbitrage profitable. The market is less transparent because transactions take place directly between two parties rather than through an exchange. Moreover, there are many currencies and any change in exchange rate requires an adjustment of the other rates. Interest rate differentials between two countries are generally offset by the forward exchange rate.

However, studies such as those by the National Bureau of Economic Research report persistent anomalies, especially after the 2008 financial crisis. Traders who can detect anomalies in milliseconds also make good money, as shown in a study by Norges bank (ANO 2005/12), one of the world's largest institutional investors.

Many people think that if an activity is rewarding for a long time, this advantage largely disappears due to competition. This is not true of the foreign exchange market. This phenomenon has been explained by Nobel laureate John Nash (1994). In the biographical film ‘A Beautiful Mind’, there is a scene showing that the collective optimum (with arbitrage rewarding) is better than the ‘every man for himself’ optimum.

Results make believe

There are several currency arbitrage funds with exceptional results. Specifically, I looked at two Dutch-based funds. One fund did not have a single negative return in 62 months after expenses(!), outperforming the S&P500. The other fund had slightly negative returns in only three months out of 50 months.

Arbitrage has the added advantage that the returns achieved are independent of traditional investments, which helps diversification. In the case of currencies, large amounts can also be allocated, making it attractive to institutional investors.

With the rise of artificial intelligence, there is yet another meaningful application, as stock markets and currencies influence each other. Shell, for example, is listed in both euros, dollars and pounds sterling: if the exchange rate or currency changes, then these prices change too. It turns out that the returns achieved by currency arbitrage funds say something about the stage towards which stock markets in particular are moving.

Closing

Since 2018, I have been assessing the investment policies of several European pension funds. What strikes me is that funds that achieved the highest returns over a 10-year period (2014-2023) (average annual returns of 8% or more) also invest in currency arbitrage. This mainly as a risk measure to be less sensitive to stock market shocks. Dutch pension funds are not among them. The three best funds only achieved an average annual return of between 6.0% and 6.5% during that period (source: OverRendement). Perhaps the transition to the new pension system offers an opportunity to explore this attractive investment option.