Covered Interest Arbitrage

Covered Interest Arbitrage

Covered Interest Strategy is an arbitrage strategy in which an investor purchases a base currency denominated investment at its spot rate and hedges the resulting foreign exchange risk by performing a forward contract sale in the financial instrument sales proceeds back into the investor’s base currency. The trade make use of a inconsistencies between interest rates and forward rates to make a riskless profit.

Covered Interest Arbitrage Opportunity

The arbitrage is only possible in two cases:

1. If the interest rate differential between two countries is less than the difference between the spot and forward exchange rate.

2. If the interest differential is greater than the difference between the spot and forward exchange rate.

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.

Covered Interest Arbitrage Example

Let us consider a investor who borrow 100,000 GBP at the spot exchange rate of $1.345/€  would exchange at  $134,500. The interest rate of 3.5% per annum would result in a future value of $139207.5.

In foreign investment,  the interest rate of 6% per annum would result in a future value of $106000. The investment of 106,000 GBP at the forward exchange rate of $1.325/€  would exchange at  $140450.

Repay the loan amount of $139,207 and get $1242.5 profit.

Check for arbitrage opportunity

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.

Uncovered Interest Arbitrage

The Uncovered Interest Strategy is an arbitrage strategy in which an investor purchases a base currency denominated investment at lower interest rate and convert to a foreign currency that offers a higher rate of interest but hedging of the resulting foreign exchange risk is not covered by performing a forward contract sale in the financial instrument.

Uncovered Interest Arbitrage Example

Let us consider a investor who borrow 100,000 GBP at the spot exchange rate of $1.345/€  would exchange at  $134,500. The interest rate of 3.5% per annum would result in a future value of $139207.5.

Let us consider two cases

1. In foreign investment,  the interest rate of 6% per annum would result in a future value of $106000. The investment of 106,000 GBP at the exchange rate of $1.325/€  would exchange at  $140450. Repay the loan amount of $139,207 and get $1242.5 profit.

2. Now the exchange rate of $1.305/€  would exchange at  $138,330. Repay the loan amount of $139,207  with a loss of $877.

The above example showed that there is no guaranteed profit in uncovered interest arbitrage.

Important points to remember

1. Spot Foreign Exchange Rate: The spot rate is the current price of the foreign exchange contract at which a buyer and a seller agree on the specified time and place.

2. Forward Exchange Contract: A  forward contract refers to buy or sell currency contract at a future date.

3. Base Currency or Domestic Currency: The currency of the domestic country in which a trader or investor is buying or sellingThe base currency, or domestic currency, is the first in a currency pair, the second currency is the quoted currency. A currency pair is a quotation featuring two different currencies. For example, in a currency exchange of USD/JPY, the base currency is the U.S. dollar and Japanese Yen is the quoted currency.

4. Carry Trade: A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an security that provides a higher interest.

5. Hedging: Hedging is a strategy to reduce the risk of price fluctuations in an asset that may be incurred by an investment.