Uncovered Interest Arbitrage

AAA

DEFINITION of 'Uncovered Interest Arbitrage'

A form of arbitrage that involves switching from a domestic currency that carries a lower interest rate to a foreign currency that offers a higher rate of interest on deposits. There is a foreign exchange risk implicit in this transaction since the investor or speculator will need to convert the foreign currency deposit proceeds back into the domestic currency some time in the future. The term "uncovered" in this arbitrage refers to the fact that this foreign exchange risk is not covered through a forward or futures contract.

INVESTOPEDIA EXPLAINS 'Uncovered Interest Arbitrage'

Total returns from uncovered interest arbitrage depend considerably on currency fluctuations, since adverse currency movements can wipe out all the gains and in fact even lead to negative returns. If the interest rate differential obtained by investing in a foreign currency is 3%, and the foreign currency appreciates against the domestic currency by 2% during the holding period, the total return from this arbitrage activity is 5%. On the other hand, if the foreign currency depreciates by 4% during the holding period, the total return is -1%.

RELATED TERMS
  1. Uncovered Interest Rate Parity ...

    A parity condition stating that the difference in interest rates ...
  2. Interest Rate Differential - IRD

    A differential measuring the gap in interest rates between two ...
  3. Currency Risk

    A form of risk that arises from the change in price of one currency ...
  4. Currency Carry Trade

    A strategy in which an investor sells a certain currency with ...
  5. Interest Rate Parity

    A theory in which the interest rate differential between two ...
  6. Yield On Earning Assets

    A financial solvency ratio that compares a financial institution’s ...
RELATED FAQS
  1. What is the theory of asymmetric information in economics?

    The theory of asymmetric information was developed in the 1970s and 1980s as a plausible explanation for common phenomena ... Read Full Answer >>
  2. How does market risk differ from specific risk?

    Market risk and specific risk are two different forms of risk that affect assets. All investment assets can be separated ... Read Full Answer >>
  3. How is perpetuity used in the Dividend Discount Model?

    The basic dividend discount model (DDM) creates an estimate of the constant growth rate, in perpetuity, expected for dividends ... Read Full Answer >>
  4. How valid is the notion of economies of scope?

    The concept of economies of scope is widely accepted in both managerial and theoretical economics. It proposes that it is ... Read Full Answer >>
  5. What is the difference between a forward rate and a spot rate?

    The forward rate and spot rate are different prices, or quotes, for different contracts. The forward rate is the settlement ... Read Full Answer >>
  6. How can a company resist a hostile takeover?

    Several different defense strategies can be applied by existing corporate boards to ward off a hostile takeover. The most ... Read Full Answer >>
Related Articles
  1. Options & Futures

    A Primer On The Forex Market

    Moving from equities to currencies requires you to adjust how you interpret quotes, margin, spreads and rollovers.
  2. Forex Strategies

    Canada's Commodity Currency: Oil And The Loonie

    When the price of oil goes up, don't worry about how much gas is going to cost - get even by making a play on the Canadian dollar.
  3. Forex Education

    Play Foreign Currencies Against The U.S. Dollar And Win

    Don't panic when the dollar drops. Learn to exploit the greenback's decline and profit from it.
  4. Options & Futures

    Using Interest Rate Parity To Trade Forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity.
  5. Economics

    What Is Supply?

    Supply is the amount of goods a producer is willing to produce at a given price, and is one of the most basic concepts in economics.
  6. Economics

    Modified Internal Rate of Return (MIRR)

    Modified internal rate of return (MIRR) is a variant of the more traditional internal rate of return calculation.
  7. Mutual Funds & ETFs

    The Top 3 Silver ETFs

    Like any tradable asset, silver and silver ETF prices are governed by the fundamental market economic forces of supply and demand.
  8. Active Trading Fundamentals

    Invest In Gold Through ETFs

    The mystique of the yellow metal captivates market players seeking hedges against inflationary pressure, safe haven in turbulent times and opportunities for speculative trading opportunities. ...
  9. Forex Strategies

    An Introduction To Trading Forex Futures

    We explain what forex futures are, where they are traded, and the tools you need to successfully trade these derivatives.
  10. Economics

    Understanding the Fisher Effect

    The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.

You May Also Like

Hot Definitions
  1. Expected Return

    The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, ...
  2. Carrying Value

    An accounting measure of value, where the value of an asset or a company is based on the figures in the company's balance ...
  3. Capital Account

    A national account that shows the net change in asset ownership for a nation. The capital account is the net result of public ...
  4. Brand Equity

    The value premium that a company realizes from a product with a recognizable name as compared to its generic equivalent. ...
  5. Adverse Selection

    1. The tendency of those in dangerous jobs or high risk lifestyles to get life insurance. 2. A situation where sellers have ...
Trading Center