the risk (currency risk) is more in this type of arbitrage.Final WordsSanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain Financial Management Concepts in Laymans Terms.Leave a ReplyCancel replyThough the gains are small in percentage terms,328. Had A invested in the U.S.,but also made anet profitof about $4,by using the covered interest arbitrage,however,we need to know what an interest arbitrage is. Different countries have different rates (both deposit and lending). For example,such a strategy is very popular among investors.ReferencesAssume investor A lives in the U.S.,it is possible that the movement in the exchange rate nullify the gain that an investor makes from the interest arbitrage. To minimize this currency risk,where the interest rate is 4%. The current USD to EUR exchange rate is 0.86. So,000.Covered interest arbitrage may look complex,but it is a pretty effective strategy. It is a low-risk strategy,investor A could benefit is by borrowing in the U.S. and then investing in Europe. This way A wont have to use his capital. He can borrow at 3% and invest it to earn 4%. However,the forward contract helps the investor to lock-in the currency rate,or eliminate arbitrage opportunity.Uncovered Interest ArbitrageA point to note is that such a strategy is only successful if the cost of the forward contract is less than the profit that an investor earns from the interest arbitrage. Suppose,while in the U.K.,where the interest rates are at 3%. However,but investors may find it challenging to make a big profit from it. So,his investment value after one-year (at 3%) would be $103,
and in turn,A decides to invest his $100,an investor invests in a foreign country offering more interest rate. However,A was not only able to avoid the currency risk,828. This is less than what he would have made by investing in the U.S. ($103,500.So,this strategy doesnt reap big benefits unless an investor buys and sells in bulk. This,in the U.S.,000 in Europe,500) $102.
328.As investment would be €89,A would have earned more by investing in the U.S. only. The total profit for A by investing in Europe would be ($107,the overall gains are massive as the investment generally runs into millions. However,an investor executes a usual interest arbitrage,000). Another way,nullify the exchange rate.An uncovered interest arbitrage is the same as the covered interest arbitrage but without the forward contract. In uncovered interest arbitrage also,440 (€86,the rate could be around 0.25%,they will move quickly to exploit it. This sudden increase in demand will quickly balance any imbalance,as well as buys a forward contract. The expiry date of the forward contract should be similar to the maturity of the foreign investment. Thus,this strategy would only be profitable if the cost of arbitrage is less than the net profit he will earn from the interest arbitrage.DrawbacksAfter one-year?
000 plus 4%*€86,000 in Europe at 4% for a year.So,in the above example,the rates could be at 0.1%. An investor can make a risk-free profit by using these different interest rates. Or,Before we explain this arbitrage,the investor does not cover theforeign exchangerisk with a forward or futures contract. So,A will convert this into USD at 1.20 and will get about $107,000). Now,borrowing from a low-interest country and investing in the country offering a higher rate. This is interest arbitrage.In this case,A would invest €86,the investor can make use of covered interest arbitrage.Let us try to understand the concept better by an example.To minimize this currency risk in a covered interest arbitrage,these arbitrage opportunities are rare. Once market participants identify any arbitrage opportunity,exposes the investor to even more risk. Despite this,328 less $4,the cost ofhedgingthe currency risk is $4.
Though it appears a risk-free strategy, it does involve current currency risk or the fluctuation risk in the currency due to the time gap in execution and maturity. This is because to invest in another country, the investor had to first convert his or her currency into a foreign currency. And, then after the maturity of the investment, convert the investment back into the local currency. Since the exchange rate is always changing, this makes the investment subject to exchange rate risk that may become unfavorable at that moment of conversion or maturity.
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Another shortcoming of this strategy is that it is complex as it involves entering simultaneous transactions in different currencies, and in different markets (spot and forward market).
Covered interestarbitrageis an investment that allows an investor to minimize their currency risk when trying to benefit from the difference in the interest rate between two countries. Such a strategy involves the use of aforward contractalong with the interestarbitrage.
Of course, with a nominal premium cost for the forward contract.
A, however, is concerned that the exchange rate after one year may not be favorable, resulting in losses for him. So, to nullify the currency risk, A executes aforwardcontract to fix the prevailing currency rate (EUR to USD) of 1.20.
Usually, the return on covered interest rate arbitrage is small as the markets nowadays are competitive, or have relatively less information asymmetry. For instance, the opportunity of covered interest arbitrage was more between GBP and USD at the time of the gold standard era. This is because information flows were slower then.
Table of Contents1Why Covered Interest Arbitrage?2Covered Interest Arbitrage Example3Drawbacks4Uncovered Interest Arbitrage5Final WordsWhy Covered Interest Arbitrage?