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You're at a fruit market. But, instead of just being able to buy apples at this fruit market, you can also sell fruit.
You're not a farmer, so you come to the market to buy some apples and you see two fruit stands. Fruit Stand A on the left
is buying and selling apples at 50 cents apiece. However, Fruit Stand B on the right is buying and selling apples at 53 cents
apiece. People are buying and selling apples at these two stands all the time, and the price at a stand could change at any
moment. But, while you're there, apples are 50 cents and 53 cents, respectively.
You're a smart person, and you quickly
realize that you can buy apples from Stand A and then sell them across the street to Stand B and make a 3-cent profit. But
you have to do it now; you can't wait. So you buy all the apples at Stand A and then run to sell them all to Stand B.
Congratulations.
You've committed fruit-stand arbitrage.
Arbitrage is exactly that: the selling of the same item between two different
markets to make a profit off the mathematical differences in price. However, it's not apples that are traded--the goods in
question are usually stocks, currencies and other securities. Arbitrage happens when you get a stock, usually a common one
like General Electric that's traded on multiple markets (Japan, Hong Kong, U.S., etc¿). The stock is usually worth within
fractions of a penny the same on each of those markets. However, there are often some minor variations.
People who
participate in arbitrage take advantage of these variations--and make a ton of money doing it. As seen in the fruit stand
example, you can make a "riskless profit" from buying and selling apples between different markets.
There are some
big hedge funds that make almost all their money off arbitrage. But, despite this simple example, arbitrage is mathematically
complex--and involves a good portion of risk if you don't know what you're doing. You probably won't be able to participate
in arbitrage directly, but you can always invest in a mutual fund that does.
Home / Personal Finance / Financial Planning
Thursday, July 24, 2008
Be Sure You Understand the Terms of That High-Yield CD
Gail Liberman and Alan Lavine
MarketWatch
PALM BEACH GARDENS, Fla.--A broker recently offered us just what the doctor ordered: An 11% rate on a bank Certificate of Deposit.
The issuer was J.P. Morgan Chase Bank (JPM). The CD, available in $1,000 increments, has a 15-year maturity and is non-callable for one year. If the CD rate were reset on July 1, it would have paid us 13.5%, the broker reported. It's possible, though, to earn no interest for that quarter.
The less heavily emphasized catch: This is a one-sided deal. You may not be able to withdraw your principal for 15 years unless you die. If the bank doesn't call it and you need to cash out, you must turn to the secondary market, where you're apt to sell it at a loss. On the other hand, the bank may call the CD quarterly whenever it wants. In that case, we'd have to reinvest our money at lower rates.
This callable CD sounds a bit different from others we've seen.
After the first year, the interest rate resets quarterly based on the "Treasury institutional swap rate." In fact, the formula is 10 times the difference between the yield on the 30-year "Constant Maturity Swap" rate and the two-year "Constant Maturity Swap" rate.
Initially, we couldn't find anyone who could identify this index. But Scott Mitchell, executive director at J.P. Morgan Securities Inc., reports it is a "hypothetical measurement designed to reflect the current rate at which such swaps transact at a predetermined fixed maturity." The indexes can be found, he says, on Reuters.
Mitchell acknowledges that there's no free lunch with this CD.
"It would be incorrect to say you would have earned that average yield [13.5%] on a per annum basis," he says. "On a CD like this, if the spreads stay as wide as they are, it's very likely J. P. Morgan would call the CD. ... We don't recommend them for a large allocation in an investor's fixed income portfolio."
Mitchell also points out that if the yield curve is inverted, and longer-term rates are lower than shorter-term rates, you could earn a below-market rate for a period. "In that case, it's unlikely we would call the note," he says.
A CD 'curve ball'
"This is like a curve ball," says Lewis Altfest, a New York-based financial planner. Altfest warns that last he checked the secondary market price for these types of programs appears to be down 20%, despite the fact that the CD rate was so high. That should serve as a cautionary clue. Meanwhile, if the two-year return were greater than the 30-year return, you'd earn zero.
While Altfest can't say whether that will happen, he believes that once the economy improves, the Federal Reserve likely will raise interest rates. Once the Fed raises rates and inflation surfaces in more areas than in food and energy, "we're going to have a potential for the two-year having a greater yield than the 30-year."
That could prove bad news for holders of this CD.
Callable CDs long have been under scrutiny by banking and securities regulators. The Securities and Exchange Commission issued a warning to investor on these programs. The SEC says:
Find out when the CD matures. Too many investors, mesmerized by the one-year rate, don't realize that you often can't withdraw from these CDs for so many years. Thoroughly check out the broker. Call your state securities regulator or check with the Financial Industry Regulatory Authority. Know whether the interest rate is fixed or variable, and read disclosure documents that tell how and how often the bank pays interest.
"A high yield long-term CD with a maturity date of 15 to 20 years may make sense for many younger investors who want to diversify their financial holdings," the SEC notes. "It may not make sense for elderly investors."
Mitchell says that amid a flight to quality, there is more interest in FDIC-protected CDs. J.P. Morgan also has been offering CDs linked to the performance of underlying stocks, bonds and commodities. It began offering CDs through external broker-dealers in 2004.
"People are looking for alternatives for yield on the back of the subprime mortgage meltdown," Mitchell explains. So expect to hear more from brokers plugging exotic bank CDs. Just don't invest without understanding all the terms.
Spouses Gail Liberman and Alan Lavine are syndicated columnists. Their latest book is "Quick Steps to Financial Stability" (Que/Penguin). You can contact them at www.moneycouple.com.
Copyright © 2008 MarketWatch, Inc.
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