Covered Interest Arbitrage

AAA

DEFINITION of 'Covered Interest Arbitrage '

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.

INVESTOPEDIA EXPLAINS '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. Uncovered Interest Arbitrage

    A form of arbitrage that involves switching from a domestic currency ...
  2. Dividend Arbitrage

    An options trading strategy that involves purchasing put options ...
  3. Arbitrage Pricing Theory - APT

    An asset pricing model based on the idea that an asset's returns ...
  4. Arbitrage

    The simultaneous purchase and sale of an asset in order to profit ...
  5. Fixed-Income Arbitrage

    An investment strategy that attempts to profit from arbitrage ...
  6. Index Arbitrage

    An investment strategy that attempts to profit from the differences ...
Related Articles
  1. Credit & Loans

    Credit Card Arbitrage: Free Money Or Dangerous Gamble?

    Credit card arbitrage is a way to make some money, but it's a major gamble with devastating risks.
  2. Look for a listed APY before paying attention to APR.
    Investing Basics

    The Interest Rates: APR, APY And EAR

    When most people shop for financial products, all they focus on is the listed interest rate. Human eyes instinctively dismiss the fine print, which usually includes the terms APR (annual percentage ...
  3. Options & Futures

    Managing Interest Rate Risk

    Learn which tools you need to manage the risk that comes with changing rates.
  4. Economics

    Understanding Interest Rates: Nominal, Real And Effective

    Interest rates can be broken down into several subcategories that incorporate various factors such as inflation. Smart investors know to look beyond the nominal or coupon rate of a bond or loan ...
  5. Options & Futures

    Arbitrage Squeezes Profit From Market Inefficiency

    This influential strategy capitalizes on the relationship between price and liquidity.
  6. Options & Futures

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  7. Options & Futures

    Using Interest Rate Parity To Trade Forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
  8. Options & Futures

    Put-Call Parity And Arbitrage Opportunity

    Look at trades that are profitable when the value of corresponding puts and calls diverge.
  9. Forex Education

    Why Interest Rates Matter For Forex Traders

    Central banks' rate changes are one of the biggest influences on the forex market.
  10. Active Trading Fundamentals

    Trade Takeover Stocks With Merger Arbitrage

    This high-risk strategy attempts to profit from price discrepancies that arise during acquisitions.

You May Also Like

Hot Definitions
  1. Deferred Revenue

    Advance payments or unearned revenue, recorded on the recipient's balance sheet as a liability, until the services have been ...
  2. Multinational Corporation - MNC

    A corporation that has its facilities and other assets in at least one country other than its home country. Such companies ...
  3. SWOT Analysis

    A tool that identifies the strengths, weaknesses, opportunities and threats of an organization. Specifically, SWOT is a basic, ...
  4. Simple Interest

    A quick method of calculating the interest charge on a loan. Simple interest is determined by multiplying the interest rate ...
  5. Special Administrative Region - SAR

    Unique geographical areas with a high degree of autonomy set up by the People's Republic of China. The Special Administrative ...
  6. Annual Percentage Rate - APR

    The annual rate that is charged for borrowing (or made by investing), expressed as a single percentage number that represents ...
Trading Center