by Irving Rivera on January 20, 2014

What is Net Interest Margin?

Much like interest rate arbitrage. net interest margin (NIM) is focus in the ability of capturing the spread between lending rates and saving rates. More specifically, is the measure of the difference between the interest income generated by banks when they lend and the amount of interest they paid to depositors. NIM is calculated by using the following equation:

Net Interest Margin = (Interest Received Interest Paid) / Average Invested Assets

value on deposits loans

This is not to be confuse with the net interest spread with is the nominal amount of difference between borrowing and lending rates:

Net Interest Margin Rate = (Interest Rate Received – Interest Rates Paid)

mortgages rates minus certificates of deposits rates

Another important consideration is the net interest income (NII) which is the analysis of actual payments amounts (revenues versus liabilities). In other words, the difference between revenues generated by interest-bearing “assets” and the cost of servicing interest-burdened “liabilities” which follows this mathematical formula in dollars terms:

Net Interest Income = (Interest Payments on Assets) − (Interest Payments on Liabilities)

monthly payments received versus payments made

In laymans terms arbitrage by; borrowing low and lending high.

How to Arbitrage Interest Rates Margin

Historically only financial institutions have been the only ones that can profit from this strategy. However, how I explain in The Arbitrager; since capitalization works exponentially faster than amortization, we can also produce net interest gains. To explain this better take a look at the following chart:

Now take look at this graph that shows the yield curve that banks use to produce net interest income. This FED produce table explains the difference between the money market saving rates and the average 10-year Treasury bill. Note that the spread on these interest rates can represent average net interest margin; or what is popularly known as the inverted yield curve:

So how can we replicate this process ourselves and start arbitraging.

Arbitrage Steps:

1. Save X amount of initial investment capital or principal.
2. Take a loan against those X saving as collateral.
3. Finally, lend out that same amount of money X back to your bank. Let’s by buying their preferred shares or bonds.

Case Study Time

There you have it, a secure and profitable way to conducted net interest margin arbitrage. Now let us create a practical example of this method. Develop an excel spreadsheet formula that can calculate the expected total return of an interest margin arbitrage trade; accounting for all costs factors.