What is Inward Arbitrage?
Inward arbitrage is a form of arbitrage that involves rearranging a bank's cash by borrowing from the interbank market and then re-depositing the borrowed money locally at a higher interest rate. The interbank market is a global network of banks, but most of the borrowing takes place between bank to bank.
The main characteristic of inward arbitrage is borrowing money globally at lower interest rates, then reinvesting the funds locally where interest rates are higher. The bank will make money on the spread between the interest rate on the local currency as well the interest rate on the borrowed currency.
- Inward arbitrage occurs when a bank receives an interbank loan at a low-interest rate and deposits the funds at a higher rate.
- The bank aims to make money on the interest rate spread.
- Inward arbitrage is the opposite mechanism to outward arbitrage.
How Inward Arbitrage Works
Inward arbitrage is the opposite of outward arbitrage, which occurs when the bank redistributes local currency into Eurobanks in order to earn more interest. Essentially outward arbitrage is taking low-interest local funds and redistributing the money into foreign markets with higher interest rates in order to make a profit. However, both inward and outward arbitrage aim to increase the bank’s spread through different currency rates and thus, different interest rates, to increase profit earned.
Inward arbitrage is profitable when a bank is able to borrow at a more favourable rate of interest than it could in the forex market. For instance, inward arbitrage would occur if a U.S.-domiciled bank can borrow from the Interbank market at, say 2%, and then deposit the borrowed Eurodollars at an American bank earning 2.5%. The greater the difference between the two interest rates, the more profit can be made from this strategy.
The goal of inward arbitrage is to earn a return with a very low, maybe even zero, risk on the profit. Inward arbitrage is only possible when the funds are able to be reinvested or redistributed into accounts with higher interest rates than their origination accounts. However, in most cases of bank inward arbitrage, the technique is used as a way to manage liabilities, not necessarily increase the bank’s note. In many instances, CDs are the preferred form of carrying out inward arbitrage.
Example of Inward Arbitrage
As an example of how inward arbitrage could work, Bank A could borrow $10,000 each from foreign Banks B, C, and D at interest rates of 1% and then redistribute the $30,000 into local Banks E and F, which offer interest rates of 1.25% and 1.35%, respectively to earn an increased return on the redistributed funds. When the interest rate of the redistributed funds out-earns the interest rates the bank must pay on the borrowed funds, the inward arbitrage has been successful.