Uncovered Interest Arbitrage

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.

BREAKING DOWN '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. Foreign Currency Effects

    The gain or loss on foreign investments due to changes in the ...
  2. Direct Quote

    A foreign exchange rate quoted as the domestic currency per unit ...
  3. Currency Substitution

    The use of a foreign currency in transactions in place of the ...
  4. Currency Pairs

    Two currencies with exchange rates that are traded in the retail ...
  5. International Currency Exchange ...

    The rate at which two currencies in the market can be exchanged. ...
  6. Currency Arbitrage

    A forex strategy in which a currency trader takes advantage of ...
Related Articles
  1. Investing Basics

    Explaining Interest Rate Parity

    Interest rate parity exists when the expected nominal rates are the same for both domestic and foreign assets.
  2. Forex Strategies

    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.
  3. Forex Education

    Forex Currencies: Trading Strategies

    By Brian PerryFor beginning investors, there are a variety of currency trading strategies available. However, most strategies fall into two broad categories: hedging and speculating. Hedging ...
  4. Trading Strategies

    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. ...
  5. Options & Futures

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  6. Professionals

    FOREIGN CURRENCY OPTIONS

    The value of one country’s currency relative to another’s is constantly changing and is known as the exchange rate. Large commercial banks exchange currencies for their own accounts ...
  7. Mutual Funds & ETFs

    Arbitrage Strategies

    Arbitrage Strategies
  8. Investing Basics

    Explaining Foreign Exchange Risk

    Foreign exchange risk is the chance that an investment’s value will decrease due to changes in currency exchange rates.
  9. Markets

    What Happens in a Currency Crisis?

    A currency crisis comes from a decline in the value of a country’s currency.
  10. Mutual Funds & ETFs

    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.
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 I invest in a foreign exchange market?

    The foreign exchange market, also called the currency market or forex (FX), is the world's largest financial market, accounting ... Read Answer >>
  4. What skills should I acquire to take advantage of arbitrage trading?

    Understand what arbitrage trading involves and what the necessary skill set is that a trader must develop in order to master ... Read Answer >>
  5. How do I use the news to find arbitrage opportunities?

    Learn what risk arbitrage trading is and how this type of arbitrage trading opportunity is available to individual retail ... Read Answer >>
  6. What models should I use to make arbitrage trades?

    Learn about different types of arbitrage models and techniques, and discover why classic arbitrage opportunities are very ... Read Answer >>
Hot Definitions
  1. Goodwill

    An account that can be found in the assets portion of a company's balance sheet. Goodwill can often arise when one company ...
  2. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  3. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  4. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  5. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  6. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
Trading Center