An old hand at arbitrage By Gene Walden (From the Minneapolis Star Tribune) When he was a student at the University of Minnesota, Trevor Cook relished every zero percent credit card offer that landed in his mail box. He would borrow the maximum from every card, reinvest the proceeds in CDs at 6 percent, and pay off the balance in full just before the penalty kicked in. Cook is still involved in arbitrage—the practice of taking advantage of a price or rate differential between two or more markets—but now he is doing it on a much grander stage. These days, Cook is making his trades on the foreign exchange market, borrowing from the Japanese market at half a percent and reinvesting in other foreign markets at around five percent. Then he leverages each transaction to bump up the effective return from 4.5 percent to about a 12 percent return for his clients. Cook and Jerry Durand, his business partner with Minneapolis-based UBS Global Advisors, sell their fixed income products to small banks, insurance companies, pension funds, registered investment advisors, and individual investors. Earlier this month, Cook and Durand set up shop in new digs at the former Van Dusen mansion, 1900 LaSalle Ave. They are part of a partnership that recently purchased the renovated, 12,000 square foot castle-like structure for just under $3 million. The home and adjoining carriage house were built in 1892 by grain baron George W. Van Dusen. It was formerly occupied by Hamline University Law School and the Horst stylist training center, among others. The grandiose mansion, with its massive crystal chandeliers and antique oak woodwork, serves as a curious backdrop to the wall of flat screen computer monitors that help Cook and Durand track foreign currency markets and bank rates around the world. Wide market interest spreads The current foreign exchange market is one of the most attractive in years, according to Cook. “When interest rate spreads are tight from one market to another, this business is not that exciting. But when spreads are wide, as they are now, that’s when it becomes lucrative and exciting.” The trading system involves what Cook terms “carry trades,” where money is borrowed at one rate and deposited at another. Cook and Durand do most their borrowing from Japan, which has a zero percent inflation rate and a ½ percent interest rate, then they reinvest in other markets, such as the U.S., where the returns are better. That gives them about a 4.5 percent spread. To increase the return, they leverage their position—in other words, they use their bond holdings to borrow money—and invest the borrowed money in additional bonds. In all, they leverage at a multiple of about 2.7, so if they buy $1 million in bonds, after leveraging, they have $2.7 million in bonds. After interest on the borrowed money and about ¼ to ½ percent to protect their position, their final leveraged yield comes to about 12 percent. Although the prospect of a 12 percent leveraged yield in the foreign exchange market sounds like the definition of high risk, Cook and Durand insist that they’ve eliminated the risk through protection methods, such as options in the derivatives market. If their foreign holdings lose value, they are hedged against the loss.  “We don’t try to guess where the markets are going,” says Cook. “We protect against all losses through hedging.” Getting started The practice of foreign exchange arbitrage is not as common in the U.S. as it is in Europe, says Durand. “That’s one of the reasons we’re in this business—it s an opportunity that I think is ahead of its time in the U.S. financial market.” Unfortunately, aside from some hedge funds that require minimum contributions in the range of $1 million, there are no mutual funds that smaller investors could buy that would offer the same type of yields. Cook and Durand do sometimes deal directly with individual investors, with a minimum investment of around $50,000. But foreign exchange arbitrage is probably not something you’ll want to try at home, warns Cook. “The brokers may tell you that you can make money trading the currency markets, but it’s just like gambling—it’s all luck. The mathematics are stacked so far against the small trader that you just can’t win.”