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. Currency Carry Trade

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

    A theory in which the interest rate differential between two ...
  3. Currency Risk

    A form of risk that arises from the change in price of one currency ...
  4. Uncovered Interest Rate Parity ...

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

    A differential measuring the gap in interest rates between two ...
  6. Current Liquidity

    The total amount of cash and unaffiliated holdings compared to ...
Related Articles
  1. thinkstock|istock
    Options & Futures

    A Primer On The Forex Market

  2. Forex Strategies

    Canada's Commodity Currency: Oil And ...

  3. Forex Education

    Play Foreign Currencies Against The ...

  4. Options & Futures

    Using Interest Rate Parity To Trade ...

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Conduit Issuer

    An organization, usually a government agency, that issues municipal securities to raise capital for revenue-generating projects ...
  3. Financing Entity

    The party in a financing arrangement that provides money, property, or another asset to an intermediate entity or financed ...
  4. Hyperinflation

    Extremely rapid or out of control inflation. There is no precise numerical definition to hyperinflation. Hyperinflation is ...
  5. Gross Rate Of Return

    The total rate of return on an investment before the deduction of any fees or expenses. The gross rate of return is quoted ...
  6. Debit Spread

    Two options with different market prices that an investor trades on the same underlying security. The higher priced option ...
Trading Center