Covered Interest Arbitrage

What is 'Covered Interest Arbitrage '

Covered interest arbitrage is a strategy in which an investor uses a forward contract to hedge against exchange rate risk. Covered interest rate arbitrageis the practice of using favorable interest rate differentials to invest in a higher-yielding currency, and hedging the exchange risk through a forward currency contract. Covered interest arbitrage is only possible if the cost of hedging the exchange risk is less than the additional return generated by investing in a higher-yielding currency. Such arbitrage opportunities are uncommon, since market participants will rush in to exploit an arbitrage opportunity if one exists, and the resultant demand will quickly redress the imbalance. An investor undertaking this strategy is making simultaneous spot and forward market transactions, with an overall goal of obtaining riskless profit through the combination of currency pairs. Covered interest arbitrage is not without its risks, which include differing tax treatment in various jurisdictions, foreign exchange or capital controls, transaction costs and bid-ask spreads.

BREAKING DOWN 'Covered Interest Arbitrage '

Returns on covered interest rate arbitrage tend to be small, especially in markets that are competitive or with relatively low levels of information asymmetry. While the percentage gains are small they are large when volume is taken into consideration. A four cent gain for $100 isn't much but looks much better when millions of dollars are involved. The drawback to this type of strategy is the complexity associated with making simultaneous transactions across different currencies.

Note that forward exchange rates are based on interest rate differentials between two currencies. As a simple example, assume currency X and currency Y are trading at parity in the spot market (i.e. X = Y), while the one-year interest rate for X is 2% and that for Y is 4%. The one-year forward rate for this currency pair is therefore X = 1.0196 Y (without getting into the exact math, the forward rate is calculated as [spot rate] times [1.04 / 1.02]).

The difference between the forward rate and spot rate is known as “swap points”, which in this case amounts to 196 (1.0196 – 1.0000). In general, a currency with a lower interest rate will trade at a forward premium to a currency with a higher interest rate. As can be seen in the above example, X and Y are trading at parity in the spot market, but in the one-year forward market, each unit of X fetches 1.0196 Y (ignoring bid/ask spreads for simplicity).

Covered interest arbitrage in this case would only be possible if the cost of hedging is less than the interest rate differential. Let’s assume the swap points required to buy X in the forward market one year from now are only 125 (rather than the 196 points determined by interest rate differentials). This means that the one-year forward rate for X and Y is X = 1.0125 Y.

A savvy investor could therefore exploit this arbitrage opportunity as follows -

  • Borrow 500,000 of currency X @ 2% per annum, which means that the total loan repayment obligation after a year would be 510,000 X.
  • Convert the 500,000 X into Y (because it offers a higher one-year interest rate) at the spot rate of 1.00.
  • Lock in the 4% rate on the deposit amount of 500,000 Y, and simultaneously enter into a forward contract that converts the full maturity amount of the deposit (which works out to 520,000 Y) into currency X at the one-year forward rate of X = 1.0125 Y.
  • After one year, settle the forward contract at the contracted rate of 1.0125, which would give the investor 513,580 X.
  • Repay the loan amount of 510,000 X and pocket the difference of 3,580 X.
RELATED TERMS
  1. Covered Interest Rate Parity

    This term refers to a condition where the relationship between ...
  2. Forward Premium

    When dealing with foreign exchange (FX), a situation where the ...
  3. Currency Forward

    A binding contract in the foreign exchange market that locks ...
  4. Uncovered Interest Arbitrage

    A form of arbitrage that involves switching from a domestic currency ...
  5. Forward Exchange Contract

    A special type of foreign currency transaction. Forward contracts ...
  6. Interest Rate Parity

    A theory in which the interest rate differential between two ...
Related Articles
  1. Trading

    Covered Interest Arbitrage

    Covered interest arbitrage is a trading strategy in which an investor uses a forward currency contract to hedge against exchange rate risk.
  2. Markets

    Interest Rate Arbitrage Strategy: How It Works

    Changes in interest rates can give rise to arbitrage opportunities that, while short-lived, can be very lucrative for traders who capitalize on them.
  3. Investing

    The Money Market Hedge: How It Works

    Investopedia explains how to hedge foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances ...
  4. ETFs & Mutual Funds

    How This New ETF Tracks Millennial Consumer Habits

    A recently launched ETF aims to track Millennial consumer habits.
  5. Trading

    Why Forward Contracts Are The Foundation Of All Derivatives

    This article expands on the complex structure of derivatives by explaining how an investor can assess interest rate parity and implement covered interest arbitrage by using a currency forward ...
  6. Financial Advisor

    How to Pick the Best Stocks? Listen to Customers (AMZN, PZZA)

    Rated top in customer service, these companies have delivered impressive stock performance over the past year.
  7. Trading

    How To Lock In An Exchange Rate

    Currency risk can be effectively hedged by locking in an exchange rate through the use of currency futures, forwards, options, or exchange-traded funds.
  8. Trading

    Arbitrage and Pairs Trading

    At a basic level, arbitrage is the process of simultaneously buying and selling the same (or equivalent) securities on different markets to take advantage of price differences and make a profit. ...
  9. ETFs & Mutual Funds

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  10. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
RELATED FAQS
  1. What are the goals of covered interest arbitrage?

    Learn the three major goals of covered interest arbitrage and increase your comprehension of the foreign exchange trading ... Read Answer >>
  2. What are the biggest risks associated with covered interest arbitrage?

    Investing money can be confusing for novice investors. Find out more about covered interest arbitrage and the risks that ... Read Answer >>
  3. How can you find the demand function from the utility function?

    Learn about how the utility function can be used to derive the demand function, and how both of these concepts relate to ... Read Answer >>
  4. How do I convert a spot rate to a forward rate?

    Learn how to convert spot rates to forward rates for financial transactions agreed to today but not to be executed until ... Read Answer >>
  5. Over what time period should I be looking at the forward rate?

    Read about forward rates and forward prices, how they function, and which rates you should look at based on your own investment ... Read Answer >>
  6. How is a share premium account taxed?

    Understand the difference between a spot rate and forward rate. Learn why someone would enter into a contract with a spot ... Read Answer >>
Hot Definitions
  1. European Union - EU

    A group of European countries that participates in the world economy as one economic unit and operates under one official ...
  2. Sell-Off

    The rapid selling of securities, such as stocks, bonds and commodities. The increase in supply leads to a decline in the ...
  3. Brazil, Russia, India And China - BRIC

    An acronym for the economies of Brazil, Russia, India and China combined. It has been speculated that by 2050 these four ...
  4. Brexit

    The Brexit, an abbreviation of "British exit" that mirrors the term Grexit, refers to the possibility of Britain's withdrawal ...
  5. Underweight

    1. A situation where a portfolio does not hold a sufficient amount of a particular security when compared to the security's ...
  6. Russell 3000 Index

    A market capitalization weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of ...
Trading Center