I think I just came up with a similar arb. technique as yours Mike, I think. The problem is, of course, directional risk. I believe that if you study the correlation of currency pairs, you can hedge against directional risk. I jsut thought of a way to double the yield that people normally get from arbitraging interest rate. For example:
If I borrow $1 USD and pay 5% interest. The Yen is currently paying 10% interest. So I convert the Dollar to the Yen to make 10%. Let's assume exchange rate is unchanged, when I later convert the Yen back to USD, I pay 5% interest on the loan and pocket 5% interest as pure profit. This is the traditionally way it is done, as taught in business school.
Using the above example, my method can achieve doubled the interest earning. After paying the interest on the loan, I end up with 10% interest earning, not 5% like the example above. Of course, I am still borrowing $1 USD at 5%.
Let's factor in directional risk of exchange rate. If the Yen appreciates in value against the USD at the time when you are converting Yen back to USD, then you pocket this extra profit in additional to the 5% interest earning. If the Yen depreciates in value against the USD, then you have up to the 5% interest earning as a layer of protection. This 5% protection applies to my method, too. (yes, i do make 10%, but in terms of per currency unit , it's still 5% protection)
So, if I can come up with a way to hedge against directional risk, I can achieve double the traditional interest earning from this arbitrage.
Nevertheless, for those who do this sort of interest arb., they have a slight edge. Statistically speaking, there's a 50% chance the exchange rate of the Yen will either appreciate or depreciate in value against the USD. In other word, there's a equal chance you will make money or lose money from a rate fluctuation. However, an interest arbitrager has 5% of interest earning as protection. From a mathematical perspective, over the long run, an interest arbitrager should be profitable.
This is like someone paying you, say, $10 to gamble with him/her where the probablility of winning or losing is a coin flip (50-50 chance). You may win, or you may lose, but you get $10 in advance just to play. Wow!
