Interest Rate Arbitrage Opportunity
Interest rate arbitrage opportunity is a strategy of buying a currency from one bank at its low rate and simultaneously selling to another bank at its high rate. If forward contract is included in the financial instrument then it is called covered interest arbitrage, otherwise uncovered interest arbitrage. Developed countries have low interest rate, but developing countries such as India and Brazil provide you high-interest rate. You can take the benefit of the interest rate difference between the US (2.5%) and developing markets like India (7%) and Brazil (10%) while keeping in mind that Interest Rate Arbitrage involves a number of risks such as transaction costs, tax policy, supply or demand inelasticity and foreign exchange controls.
Check for arbitrage opportunity
Forward Rate/Spot Rate = (1 + Interest Rate of Base country)/ (1 + Interest Rate of Foreign country)
1. Rb = Interest rate in Base Country
2. Rf = Interest rate in Foreign Country
3. F= Forward Exchange Rate
4. S= Spot Exchange Rate
LHS = F / S
RHS = (1+Rb)/(1+Rf)
Case 0: LHS = RHS. There is no arbitrage opportunity.
Case 1: LHS > RHS.
There is inconsistency between interest rates and forward rates, and thus arbitrage opportunity. In this case, borrow base currency, convert at spot, invest in foreign and convert back to base at forward.
Case 2: LHS < RHS.
There is mismatch between interest rates and forward rates, and thus arbitrage opportunity. In this case, borrow foreign, convert at spot, invest in base and convert back to foreign at forward.
Rf = 0.06
Rb = 0.035
F = $1.325/€
S = $1.345/€
F/S = $1.325/€ / $1.345/€ = 0.98513
(1+Rb) / (1+Rf) = 1.035 / 1.06= 0.98
There is inconsistency between interest rates and forward rates, and thus arbitrage opportunity.