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If I live in the US, for example, where current interest rates are practically nil, how can I take advantage of the fact that interest rates in Australia are almost 5%?

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While this may seem like a good idea, it's not really what it seems.

Here's why. Your money is in US dollars. You're going to have to use those USD to buy Australian dollars before you can buy the Australian bonds.

When you sell the Australian bonds, you're going to have to convert the money back from Australian currency to US Dollars.

In the meantime, the Australian dollar may have gone up, or gone down. So you're taking a very big currency risk.

There is a way to solve this problem: you can use currency futures to hedge against this currency risk. What that means is, essentially, that you buy insurance against the possibility that the Australian dollar goes down.

The cost of this insurance reduces the money you make. In fact, it's going to reduce it by almost exactly the difference between Australian and US interest rates. Why? Well, because the insurance (currency futures) trades freely, the Australian bonds trade freely, and US bonds trade freely, too, so if there was such a thing as a "free lunch" other speculators would have arbitraged it away. The three rates (Australian interest rate, US interest rate, and the price of currency futures) MUST and WILL move in tandem.

SO... while you might THINK that you're getting a 5% rate instead of a 0% rate, what you're really doing is making a bet on the future direction of the Australian currency relative to the US currency. That might not be something you expected, and unless you have a strong desire to speculate in currency and take macro-economic views on where various currencies are going, this is probably not the investment you thought it was.

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    People have also regularly been screwed in the other direction, by borrowing at a great low rate in foreign currency A, and then needing to pay it back from an income in depreciating income B. – poolie Dec 2 '10 at 0:56
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    It's also worth mentioning that you may well have to pay tax on the coupon in either country A or B or at worst both, which will cut that 5% substantially. Individual investors may be much worse off at this than larger traders. – poolie Dec 2 '10 at 0:57
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    While what Joel says is true, it is important to realize that to invest in the US rather than in Australia also is a bet on the USD vs the other options. Just because you happen to be living in the US doesn't mean that investing in the US is less of a bet than investing elsewhere. – JDelage Dec 2 '10 at 13:55
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    JDelage it's less of a bet to invest in the same currency you will spend. To minimize risk you'd want to invest a similar percentage in a currency that you spend in that currency. If you buy groceries in the US, invest your grocery money in dollars. (If your home currency has nasty inflation you could get hosed, and diversifying a piece of your portfolio into global bonds can be smart, but if you spend in dollars, dollars aren't as risky as foreign currencies.) Graph cost of groceries in dollars at a US store, vs. in Euros at same store, you'll have a lot more bounce in the Euro cost. – Havoc P Dec 3 '10 at 4:12
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    Great answer, although it does rely on the "efficient market hypothesis" (those smart traders would've gotten any arbitrage), which hasn't always proven to be true. – dfrankow Dec 5 '10 at 1:06
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Since this question got bumped, I decided to look at how such an investment would've played out over the last seven years.

Today, Dec. 6th, 2017: 1 AUD = 0.758248 USD

On Dec. 6th, 2010: 1 AUD = 0.987948 USD

Thus, the Australian dollar has declined at an annualized rate of 3.71% over the last seven years.

So that would eat most of the gains you would've had, if you you were able to maintain a 5% investment.

But it looks like interest rates have dropped in Australia in the past few years. The central bank rate was >4% when this question was posted but is 1.5% now.

Variable rate mortgages were at 8.30% in Dec 2010, to 5.10% in July 2017 (the link didn't have anything more recent, and I didn't look that hard).

It's unlikely that such an investment strategy would have broken even, and probably ended up with a net loss, especially considering any taxes and fees involved.

  • Carry trade is actually a historically winning strategy and looks to be the case going forward. It's just not as simple as buy and hold. – xiaomy Dec 6 '17 at 16:09
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  1. How can I take advantage of the fact that interest rates in Australia are almost 5%

You can approach an Australian bank and ask them if they can take a deposit from a US person, and shop interest rates around. Different countries have different rules, but if you have enough money (and the banks will make enough profit) doors will open.

The biggest obstacle you may find is that they might not want to open an account if you are not resident in Australia, or that you're not big enough of a customer to open an 'overseas customer' account.

If you do succeed, there are some areas of concern:

  1. Foreign Exchange (FX) Risk

The banks in Australia will not provide you with that rate on US Dollars, but Australian Dollars. The exchange rate between the US dollar and Australian dollar fluctuates - in a large part due to interest rates. If the US dollar were to increase its rate (as expected shortly) the US dollar will most likely go up relative to the Australian Dollar. Which in turn would mean that when you bring your money back into the US from Australia, you will get fewer US dollars for it.

  1. Inflation Risk

Interest rates are often primarily used by the countries' central banks to keep the rate of inflation under control. Typically they expect inflation to be at about 2% - meaning that in $100 in one year is only worth $98 the next. Countries with higher interest rates tend to have higher inflation (e.g. Brazil, India, etc.).

  1. Regulatory Risk

In the US if your bank fails FDIC insurance steps in. If your deposits are under the threshold, FDIC will guarantee you will get your money bank. Other countries have different schemes but notably Iceland who were offering British investors high interest rates in their own local currency (British Pounds) left them out when the Icelandic banking system collapsed (in a large part because there wasn't enough money to go around). That probably won't happen again in the near term, but it is the kind of thing you need to be aware of.

Also, the US Treasury introduced reporting of Foreign Bank and Financial Accounts (FBAR) which requires you to declare all accounts abroad if at any time during the calendar year, their total balance exceeded $10,000 - another piece of paper to file at the same time as your tax return.

The foreign bank will not provide you with a 1099 form for reporting your taxes, so you will need to figure it out and report it yourself. They may also automatically deduct Australian taxes from any interest paid.

Currency Futures

While I agree that you could also do this type of trade in the futures market, there is still 'spread' and other inefficiencies. Right now on CME only the front month seems to have any signifiant activity. Most big banks are able to offer their institutional customers prices for 'forwards' (non-exchange traded 'forward' (as opposed to 'future') currency contracts). As expected, if you used these to eliminate the FX rate risk, your resulting interest rate would not be as high.

The Rate

According to my broker, the Reserve Bank of Australia Daily Cash Rate is only 1.25%, while the US Fed Funds Rate is 1.16%. Looking at Australian government bonds referenced, the one expiring October 2019 (GSBE19) pays a coupon of 5.5% but is trading at a premium above its par value ($105.764 for a $100 bond). This brings down the effective rate (yield to maturity) to something below 2%.

  • FBAR filing has been online only (no paper) for several years; and to be clear although the date is now the same as tax returns it is not in or with your tax return. In addition above a higher threshold that varies with your status you must also report foreign assets on form 8938 which is part of your tax return. See irs.gov/businesses/… . On the bright(?) side, if you do have to pay foreign tax on income, you get a credit against (but not exceeding) your US tax on that income. And note the 5% rate in the Q was 7 years ago. – dave_thompson_085 Dec 8 '17 at 7:12
  • @dave_thompson_085 good points. Sorry - I wasn't meaning 'paper' that literally; agree about 8938 but left it out for clarity; bonds cited by OP still pay a coupon of above 5% just that the market prices of said securities reflect a lower rate (now). – xirt Dec 9 '17 at 3:53

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