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. Foreign Exchange Risk

    1. The risk of an investment's value changing due to changes ...
  3. Currency Substitution

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

    The simultaneous purchase and sale of an asset in order to profit ...
  5. Currency Pairs

    Two currencies with exchange rates that are traded in the retail ...
  6. Covered Interest Rate Parity

    This term refers to a condition where the relationship between ...
Related Articles
  1. Investing

    Explaining Interest Rate Parity

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

    Protect Your Foreign Investments From Currency Risk

    Hedging against currency risk can add a level of safety to your offshore investments.
  3. 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.
  4. Trading

    Trading The Odds With Arbitrage

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

    Explaining Foreign Exchange Risk

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

    What Happens in a Currency Crisis?

    A currency crisis comes from a decline in the value of a country’s currency.
  7. Investing

    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.
  8. Trading

    The Effects Of Currency Fluctuations On The Economy

    Currency fluctuations are a natural outcome of the floating exchange rate system that is the norm for most major economies. The exchange rate of one currency versus the other is influenced by ...
  9. Trading

    What is an Indirect Quote?

    An indirect quote expresses the amount of foreign currency required to buy or sell one unit of the domestic currency in the foreign exchange 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. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  2. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  3. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  4. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  5. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  6. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
Trading Center