Why is it so much cheaper to borrow money in Euros?

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johnanglemen
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Why is it so much cheaper to borrow money in Euros?

Post by johnanglemen » Mon Sep 17, 2018 1:14 pm

This is probably an obvious question but I'll ask it anyway.

If you want to borrow, say, $2 million USD on margin at Interactive Brokers, you'll pay around 2.65% annually for the privilege.

But if you want to borrow the equivalent amount in Euros, you'll only pay around 0.75%.

Why is there such a difference? And I know there's no such thing as a free lunch, so what makes the EUR rate not actually better despite appearances?

imperia
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Re: Why is it so much cheaper to borrow money in Euros?

Post by imperia » Mon Sep 17, 2018 1:50 pm

European Central Bank still hold interest low near zero, on the oder side FED has rise interest couple times.

Kevin8696
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Re: Why is it so much cheaper to borrow money in Euros?

Post by Kevin8696 » Mon Sep 17, 2018 1:58 pm

johnanglemen wrote:
Mon Sep 17, 2018 1:14 pm
This is probably an obvious question but I'll ask it anyway.

If you want to borrow, say, $2 million USD on margin at Interactive Brokers, you'll pay around 2.65% annually for the privilege.

But if you want to borrow the equivalent amount in Euros, you'll only pay around 0.75%.

Why is there such a difference? And I know there's no such thing as a free lunch, so what makes the EUR rate not actually better despite appearances?
If you are borrowing in Euros, and then converting the proceeds of the loan to USD to trade on US markets, you are taking on a good bit of currency risk. USD is pretty strong right now, but was on it's butt last year. A drop in the value of USD relative to Euros could sting quite a bit when you go to repay the margin loan with Euros.

international001
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Re: Why is it so much cheaper to borrow money in Euros?

Post by international001 » Mon Sep 17, 2018 2:33 pm

euro loans have also much lower rates. euro bank accounts offer lower rates as well

What I cannot understand is why USD value respect euro doesn't decrease at the difference of the rate. It would seem you can arbitrage the whole thing (get a loan in euros, invest in USD, pay back in Euros)

MrJones
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Re: Why is it so much cheaper to borrow money in Euros?

Post by MrJones » Mon Sep 17, 2018 2:37 pm

international001 wrote:
Mon Sep 17, 2018 2:33 pm
euro loans have also much lower rates. euro bank accounts offer lower rates as well

What I cannot understand is why USD value respect euro doesn't decrease at the difference of the rate. It would seem you can arbitrage the whole thing (get a loan in euros, invest in USD, pay back in Euros)
Until you get hit by the currency risk you're taking.

johnanglemen
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Re: Why is it so much cheaper to borrow money in Euros?

Post by johnanglemen » Mon Sep 17, 2018 2:40 pm

Kevin8696 wrote:
Mon Sep 17, 2018 1:58 pm
johnanglemen wrote:
Mon Sep 17, 2018 1:14 pm
This is probably an obvious question but I'll ask it anyway.

If you want to borrow, say, $2 million USD on margin at Interactive Brokers, you'll pay around 2.65% annually for the privilege.

But if you want to borrow the equivalent amount in Euros, you'll only pay around 0.75%.

Why is there such a difference? And I know there's no such thing as a free lunch, so what makes the EUR rate not actually better despite appearances?
If you are borrowing in Euros, and then converting the proceeds of the loan to USD to trade on US markets, you are taking on a good bit of currency risk. USD is pretty strong right now, but was on it's butt last year. A drop in the value of USD relative to Euros could sting quite a bit when you go to repay the margin loan with Euros.
What if you're just borrowing money to invest in Vanguard Total Stock Market? It seems you could borrow in Euros and invest (in Euros) in the ETF, instead of doing the same in USD?

alter
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Re: Why is it so much cheaper to borrow money in Euros?

Post by alter » Mon Sep 17, 2018 2:50 pm

You could always borrow in Euros to invest in USD-EUR forex futures :)

Kevin8696
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Re: Why is it so much cheaper to borrow money in Euros?

Post by Kevin8696 » Mon Sep 17, 2018 2:52 pm

johnanglemen wrote:
Mon Sep 17, 2018 2:40 pm
Kevin8696 wrote:
Mon Sep 17, 2018 1:58 pm
johnanglemen wrote:
Mon Sep 17, 2018 1:14 pm
This is probably an obvious question but I'll ask it anyway.

If you want to borrow, say, $2 million USD on margin at Interactive Brokers, you'll pay around 2.65% annually for the privilege.

But if you want to borrow the equivalent amount in Euros, you'll only pay around 0.75%.

Why is there such a difference? And I know there's no such thing as a free lunch, so what makes the EUR rate not actually better despite appearances?
If you are borrowing in Euros, and then converting the proceeds of the loan to USD to trade on US markets, you are taking on a good bit of currency risk. USD is pretty strong right now, but was on it's butt last year. A drop in the value of USD relative to Euros could sting quite a bit when you go to repay the margin loan with Euros.
What if you're just borrowing money to invest in Vanguard Total Stock Market? It seems you could borrow in Euros and invest (in Euros) in the ETF, instead of doing the same in USD?
ETF's are exchange traded funds. Which exchange will allow you to trade USD-denominated securities in Euros ?
Last edited by Kevin8696 on Wed Sep 19, 2018 9:04 am, edited 1 time in total.

bberris
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Re: Why is it so much cheaper to borrow money in Euros?

Post by bberris » Mon Sep 17, 2018 3:57 pm

international001 wrote:
Mon Sep 17, 2018 2:33 pm
euro loans have also much lower rates. euro bank accounts offer lower rates as well

What I cannot understand is why USD value respect euro doesn't decrease at the difference of the rate. It would seem you can arbitrage the whole thing (get a loan in euros, invest in USD, pay back in Euros)
As I think you have guessed, there is no arbitrage opportunity here. In order to remove the currency risk, you would have to buy euro futures. The cost will cancel out the interest rate difference. Markets for currency and debt are very efficient.

But why are Euro interest rates lower? Yes the ECB pushes rates down. But purchasing power of the Euro is better than the dollar, and expected inflation in Euro currency countries is lower.

international001
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Re: Why is it so much cheaper to borrow money in Euros?

Post by international001 » Tue Sep 18, 2018 4:05 am

I won't claim to be an expert on currency trading

But on top of any other risk, wouldn't the expectation of euros per dollar have to increase 2% annually? 2% is how much higher rates are in US. Isn't it the same concept if you have a overheated economy with 10% rates.

I don't understand why do you mean of better purchasing power of the euro. You mean if you convert USD to euros (taxes aside), an iphone will be cheaper?

bberris
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Re: Why is it so much cheaper to borrow money in Euros?

Post by bberris » Tue Sep 18, 2018 9:31 am

OECD data from 2017
https://data.oecd.org/conversion/purcha ... es-ppp.htm
shows PPP of 0.750 for the Euro using-countries. That means an exchange rate of 1.333 dollars per euro gives you equal purchasing power in the US and Euro zone. The current exchange rate is 1.17. In order to buy the same goods with Euros and dollars, the euro should appreciate by 14 %.

It's a good time to visit Europe.

Valuethinker
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Re: Why is it so much cheaper to borrow money in Euros?

Post by Valuethinker » Tue Sep 18, 2018 10:49 am

johnanglemen wrote:
Mon Sep 17, 2018 1:14 pm
This is probably an obvious question but I'll ask it anyway.

If you want to borrow, say, $2 million USD on margin at Interactive Brokers, you'll pay around 2.65% annually for the privilege.

But if you want to borrow the equivalent amount in Euros, you'll only pay around 0.75%.

Why is there such a difference? And I know there's no such thing as a free lunch, so what makes the EUR rate not actually better despite appearances?
1. monetary policy determines the general level of interest rates. The European economy as a whole is much less strong than the US one, and so the ECB is keeping interest rates down. The Federal Reserve, worried about future inflation, is slowly raising US rates back towards pre Crisis normal.

2. If you covered the borrowing with a FX forward or future it would cost about as much as the difference in interest rates.

So if you planned to repay the $2m in Euros in USD in 12 months time, the cost of buying the forward contract to do that would be approximately 1.9% (ie 2.65 - 0.75).

That last relationship is called Covered Interest Parity. Except for market maker spreads, it pretty much holds. You cannot do your suggested strategy risk free.

A related concept is Uncovered Interest Parity. Let's say you do this (borrow in Euros to invest in Dollars) but don't hedge your currency exposure. The USD should depreciate by enough over that time to wipe out your potential profit from borrowing cheaply.

That does not hold perfectly. The data (which is noisy) suggests a strategy of borrowing in the low rate country and investing in the high interest rate country does, on average, generate profits. The depreciation of the USD is not enough to offset the higher interest rate in the USA. This is called the "carry trade".

2 howevers:

- since that data became clear, a lot of funds and strategies were established to do precisely this. So the gain got arbitraged away

- the strategy is subject to event risk. Iceland was paying 15% on deposits when Eurozone was paying 5%. Hungarians could borrow in Forints at 12% or Eurozone mortgages at 6%. etc.

Then, the financial crisis hit. Iceland froze bank deposits and imposed exchange controls, and the currency fell ?40%? You took big losses as a currency speculator. Meanwhile Hungarians found the principal and interest payments of their mortgage in Swiss Francs or Euros doubled when the currency fell out of bed.

So it's not a free win. It is a "picking up nickels in front of bulldozers" strategy. You will make a little (or a lot) of money most of the time. Every so often, you will get wiped out.

international001
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Re: Why is it so much cheaper to borrow money in Euros?

Post by international001 » Wed Sep 19, 2018 2:59 am

bberris wrote:
Tue Sep 18, 2018 9:31 am
OECD data from 2017
https://data.oecd.org/conversion/purcha ... es-ppp.htm
shows PPP of 0.750 for the Euro using-countries. That means an exchange rate of 1.333 dollars per euro gives you equal purchasing power in the US and Euro zone. The current exchange rate is 1.17. In order to buy the same goods with Euros and dollars, the euro should appreciate by 14 %.

It's a good time to visit Europe.
IT would depend on which country you go. Greece or France are not the same. It's about the goods on the country. I'm taking just currency conversion

international001
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Re: Why is it so much cheaper to borrow money in Euros?

Post by international001 » Wed Sep 19, 2018 3:06 am

Valuethinker wrote:
Tue Sep 18, 2018 10:49 am
johnanglemen wrote:
Mon Sep 17, 2018 1:14 pm
This is probably an obvious question but I'll ask it anyway.

If you want to borrow, say, $2 million USD on margin at Interactive Brokers, you'll pay around 2.65% annually for the privilege.

But if you want to borrow the equivalent amount in Euros, you'll only pay around 0.75%.

Why is there such a difference? And I know there's no such thing as a free lunch, so what makes the EUR rate not actually better despite appearances?
1. monetary policy determines the general level of interest rates. The European economy as a whole is much less strong than the US one, and so the ECB is keeping interest rates down. The Federal Reserve, worried about future inflation, is slowly raising US rates back towards pre Crisis normal.

2. If you covered the borrowing with a FX forward or future it would cost about as much as the difference in interest rates.

So if you planned to repay the $2m in Euros in USD in 12 months time, the cost of buying the forward contract to do that would be approximately 1.9% (ie 2.65 - 0.75).

That last relationship is called Covered Interest Parity. Except for market maker spreads, it pretty much holds. You cannot do your suggested strategy risk free.

A related concept is Uncovered Interest Parity. Let's say you do this (borrow in Euros to invest in Dollars) but don't hedge your currency exposure. The USD should depreciate by enough over that time to wipe out your potential profit from borrowing cheaply.

That does not hold perfectly. The data (which is noisy) suggests a strategy of borrowing in the low rate country and investing in the high interest rate country does, on average, generate profits. The depreciation of the USD is not enough to offset the higher interest rate in the USA. This is called the "carry trade".

2 howevers:

- since that data became clear, a lot of funds and strategies were established to do precisely this. So the gain got arbitraged away

- the strategy is subject to event risk. Iceland was paying 15% on deposits when Eurozone was paying 5%. Hungarians could borrow in Forints at 12% or Eurozone mortgages at 6%. etc.

Then, the financial crisis hit. Iceland froze bank deposits and imposed exchange controls, and the currency fell ?40%? You took big losses as a currency speculator. Meanwhile Hungarians found the principal and interest payments of their mortgage in Swiss Francs or Euros doubled when the currency fell out of bed.

So it's not a free win. It is a "picking up nickels in front of bulldozers" strategy. You will make a little (or a lot) of money most of the time. Every so often, you will get wiped out.
Thanks for the explanation. I'm sure you must be right. Arbitration cannot exist long term

So 'Uncovered Interest Parity' is the scenario that I was referring to. Difference in interest rates cause one currency to devaluate. 'Covered Interest Parity' is the opposite case and what it seems to be happening now USD/EUR. When would the former happen? When it's perceived by the markets that those interest rates are permanent or predictable?

Valuethinker
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Re: Why is it so much cheaper to borrow money in Euros?

Post by Valuethinker » Wed Sep 19, 2018 3:45 am

international001 wrote:
Wed Sep 19, 2018 3:06 am


Thanks for the explanation. I'm sure you must be right. Arbitration cannot exist long term
I am guessing that English is not your first language? So just to clarify

Arbitration = the act of a third party (such as a judge) to oversee mediation between 2 opposing sides (Labour arbitration between Trade Unions and employers).

"arbitrage" = the process in markets of exploiting differences in prices of the same commodity or financial product. I think there is a very form "to arbite" but it's not widely used.

Arbitrage *always* exists - in any market there are participants selling the expensive and buying the cheap (George Soros comes to mind; see also the Steve Eisman/ "Ed Baum"/ Steve Carrell character in The Big Short, also the Brad Pitt character). When it fails as it does periodically, then you get strange divergences.

What is generally true is that large arbitrage profits cannot exist long term as long as there are no restraints on the actions of arbitrageurs. Controlled exchange rates are an example of such restraints - and countries that have them are generally in a tug of war with currency speculators.
So 'Uncovered Interest Parity' is the scenario that I was referring to. Difference in interest rates cause one currency to devaluate. 'Covered Interest Parity' is the opposite case and what it seems to be happening now USD/EUR. When would the former happen? When it's perceived by the markets that those interest rates are permanent or predictable?
Covered Interest Parity will hold almost always between major currency pairs. The main differences will be the buy sell (bid ask) spread that the dealers will charge you for each transaction.

Invest in USD & buy a 3m currency Forward to sell USD & buy EUR (a Forward is just a contract, like a Futures contract, but not exchange traded)

vs.

Exchange USD for EUR now and invest in a fixed term deposit in EUR for 3m

In both cases you wind up with EUR. And in both cases you will wind up with the same amount of money. There may be small differences but if there were large differences, it's a pretty easy arbitrage to exploit so the markets will drive the returns of the 2 strategies together, by moving the spot and/or forward exchange rate.

Uncovered Interest Parity

It's unclear why the relationship does not hold. Partly it is market error - expectations of the future are not correct*. I am not sure what the latest economic theories are regarding UIP but it is held generally in FX markets that because you have participants who are not seeking to make a profit, there are exploitable opportunities.

These not profit maximizing participants would include those who need FX to conduct business (me going on holiday to USA, say) and also Central Banks trading to stabilize/ manage exchange rates aka "dirty Float" which is how exchange rates are done these days (since the end of Bretton Woods in 1971, exchange rates for the major currencies are not fixed, but on the other hand the Central Banks do intervene to move exchange rates around).

* but that implies systematic error - that the markets misjudge on a predictable basis and direction. The ability to buy the high interest rate currency and profit (in your own currency terms) because the exchange rate does not depreciate fully to compensate. That seems to work as a strategy with caveats: noisy data; event risk.

Mrs Watanabe is a stock figure in world finance. She is the Japanese housewife who conducts the "Yen carry trade" of borrowing in Japan (at near 0%) and buying high interest currencies (then: Iceland & New Zealand). Post 2008 we don't hear much about her because interest rates have fallen so far in other countries.

The Yen moved up against the dollar 14% in one day during the 1997-98 Asia Crash. That was the sound of Japanese investors, who were long in dollars, selling out-- unwinding the carry trade. It is an unbelievable scale of change for a currency pair that is top 3-4 of world traded currency pairs.

carguyny
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Re: Why is it so much cheaper to borrow money in Euros?

Post by carguyny » Wed Sep 19, 2018 5:27 am

True risk free trade the cost will be within 1 or 2 bps of each other. You need to borrow Euro, convert to USD at spot, have small forwards on coupon payments, have maturity payment forward for principal. Last time I needed to calc it all out, they happened to be spot on - ignoring transaction costs.

msk
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Re: Why is it so much cheaper to borrow money in Euros?

Post by msk » Wed Sep 19, 2018 5:52 am

There are some opportunities in small countries where the local currency is pegged to the USD, in some cases for several decades. In such countries it sometimes happens that one can get a CD in local currency that pays you more, say, 4%, than the same bank charges you on a USD loan, say, 3%. This is simply a reflection of a sense of insecurity that even the locals have in their own local economy, despite decades of a fixed peg. In the 1970s a Dutch friend borrowed in Swiss Francs to buy an apartment in The Hague. It did not take many months before he regretted his choice! We all know how strong the Swiss Franc behaved in those decades.

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Re: Why is it so much cheaper to borrow money in Euros?

Post by LadyGeek » Wed Sep 19, 2018 2:43 pm

This thread is now in the Investing - Theory, News & General forum (general question).
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Valuethinker
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Re: Why is it so much cheaper to borrow money in Euros?

Post by Valuethinker » Thu Sep 20, 2018 7:20 am

msk wrote:
Wed Sep 19, 2018 5:52 am
There are some opportunities in small countries where the local currency is pegged to the USD, in some cases for several decades. In such countries it sometimes happens that one can get a CD in local currency that pays you more, say, 4%, than the same bank charges you on a USD loan, say, 3%. This is simply a reflection of a sense of insecurity that even the locals have in their own local economy, despite decades of a fixed peg. In the 1970s a Dutch friend borrowed in Swiss Francs to buy an apartment in The Hague. It did not take many months before he regretted his choice! We all know how strong the Swiss Franc behaved in those decades.
There were. And this is why fixed exchange rates require currency controls. China for example.

Particularly as a result of the financial crash, wise national financial services regulators severely restrict mortgage borrowing in a foreign currency. They are hard to get in the UK (borrowing in EUR or USD or CHF) and require large equity (typically 40%+ I believe). FCA (SEC like body) has really weighed in on them.

If you are a Non Resident Indian you can lend to an Indian bank at something like 7% in USD. We have threads here. This is a great wheeze to make money, until it is not. In other words, if India had a FX crisis, you might find that money was frozen. Until then, it's a money machine - an arbitrage that does not close. As long as it doesn't get too big it seems the Reserve Bank of India does not view it as a threat.

Whereas pre the 1997-98 Crash the global financial wisdom was that free exchange rates with no capital controls was the best of all possible worlds, since then it's become part of the IMF standard bailout package that you must impose currency controls if you request a bailout.

For a long time in Iceland you could only buy foreign currency for non business purposes by buying it on ebay or other online exchanges, from other Icelanders. Not sure whether they have finally abolished those, but they were imposed in 2008.

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Re: Why is it so much cheaper to borrow money in Euros?

Post by Valuethinker » Thu Sep 20, 2018 7:22 am

I cannot remember the exact nostrum, but it runs along the lines of:

You can have:

- free floating exchange rate
- no currency controls
- independent monetary policy

You can have any 2 of those, but not all 3.

We live in an era of "dirty floats" (free floating XR with periodic Central Bank interventions).

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