How to make a bet on interest rates

April 5, 2009 10:17 AM

How do I, as a small investor in Canada, make a bet, (preferably leveraged) as to what interest rates are going to be in 5 years?

My wife and I are buying a condo, and I want to protect us from being hit by high interest rates. (We bought pre-construction, there's no way out of it, and we've accepted it and moved on. We move in in a year.) Problem is, in Canada, people usually take a 5 or 10 year fixed term, and the rate for a 5 year term is at 4%, while a 10 year term is at 5.25%. A 25 year mortgage is crazy expensive. Check out www.canequity.com.

Really what I'd like to do is buy something akin to an out of the money call option. Spend a small amount to make a bet that will likely be worth zero, but pays off huge if an unlikely event happens. There's general agreement that rates are likely to be higher 5 years from now. The bet I want to make would be on rates are substantially higher than pretty much anyone expects.

Essentially, I want to take the lower, 5 year rate on our mortgage, and then hedge, so that we're not in pain if the rate goes up huge in the meantime. Based on the price of this bet, I might be persuaded to take the 10-year term.

I don't know what kind of security I could buy that would do this. I know that certain sectors of the stock market are interest rate sensitive, but I want something more closely linked to interest rates.

Thanks!

posted by thenormshow to work & money (5 comments total)

Options on Bond Futures. Probably someone will know better then I but I'm pretty sure you won't be able to find any liquidity even 5 years out tho. No one will want to stand on the other side of the bet. Besides given the timeframe you have they would be really expensive if someone was looking to trade with you. Bear in mind the fact that gaps between the 5-10-25 is so large is indicative of the fact that the market already expects rates to go up a lot - and the guys pricing the implied interest rate risk in the mortgages probably know how to do that better then you or I.


If you just want to bet on rates going up there are ETFs that are short longer duration treasuries - but in order to get the kind of return you want you'd have to margin them - and then you would need to be able to make the margin calls when they come. I think some ETFs are optionable - but once again with the kind of maturity there is little to no liquidity. And if you can't find the liquidity in the US I sort of doubt you can find it for Canadian instruments.
posted by JPD at 10:49 AM on April 5 [1 favorite]

The Canadian Institute of Actuaries does this on a monthly basis, albeit for a different application.

But, especially if you agree with the Efficient Market Hypothesis, there's no point trying to bet. Arbitrage is best left to the professionals who spend all their waking moments thinking about it.
posted by randomstriker at 5:27 PM on April 5

But, especially if you agree with the Efficient Market Hypothesis, there's no point trying to bet. Arbitrage is best left to the professionals who spend all their waking moments thinking about it.

No, that's rubbish. What he's doing is the equivalent of taking out insurance.
posted by I_pity_the_fool at 9:09 AM on April 6

Actually he's betting he can buy the insurance more cheaply then it is currently being offered by the market. The cost of the insurance is part of the 125bps price differential between a 5 yr and 10 yr mortgage.
posted by JPD at 10:31 AM on April 6

Those "professionals" who randomstriker is referencing, on average do about as well as a monkey throwing darts at random stocks and investment platforms that are pinned to the wall, hence the title of Burton Malkiel's book "a random walk down wall street".
posted by zentrification at 2:19 PM on April 6