What is 'Covered Interest Arbitrage '

Covered interest arbitrage is a strategy in which an investor uses a forward contract to hedge against exchange rate risk. Covered interest rate arbitrages 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 -- hence the word arbitrage. 

BREAKING DOWN '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.

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 risk-less profit through the combination of currency pairs.

Example

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. Forex Arbitrage

    Forex arbitrage is the simultaneous purchase and sale of currency ...
  2. Index Arbitrage

    Index arbitrage is a trading strategy that attempts to profit ...
  3. Forward Premium

    A forward premium occurs when the expected future price of a ...
  4. Statistical Arbitrage

    Statistical arbitrage is a profit situation arising from pricing ...
  5. Triangular Arbitrage

    Triangular arbitrage involves the exchange of a currency for ...
  6. Conversion Arbitrage

    Conversion arbitrage is an options trading strategy employed ...
Related Articles
  1. 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.
  2. Investing

    How This New ETF Tracks Millennial Consumer Habits

    A recently launched ETF aims to track Millennial consumer habits.
  3. Investing

    How Precious Metals Like Gold Can Be Arbitraged

    Arbitrage trading involves a lot of risk and can get challenging. Find out how to benefit from the price differential between the buy and sell price.
  4. Financial Advisor

    10 Companies With No Debt (DOX,NHTC,PAYX)

    These 10 companies have no debt, a big positive in today's economic environment. Three stand out above the rest.
  5. Investing

    How Statistical Arbitrage Can Lead to Big Profits

    Statistical arbitrage is one of the most influential trading strategies ever devised. Learn how it is leveraged by investors and traders seeking profits.
  6. Investing

    3 Mutual Funds Focusing on Arbitrage Profits (MERFX, ARBFX)

    Get details on three of the most popular mutual funds for investors interested in arbitrage trading.
  7. Investing

    How ETF Arbitrage Works

    ETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. Learn how it works.
  8. Investing

    Hedge Funds Hunt for Upside, Regardless of Market

    Hedge funds seek positive absolute returns through aggressive strategies to make this happen.
RELATED FAQS
  1. How do I use the news to find arbitrage opportunities?

    Learn what risk arbitrage trading is and how this type of opportunity is available to individual retail investors. Read Answer >>
  2. How do I use an arbitrage strategy in forex trading?

    See how forex arbitrage acts upon opportunities presented by pricing inefficiencies through the buying and selling of different ... Read Answer >>
  3. What is the Difference Between a Forward Rate and a Spot Rate?

    The forward rate is the settlement price of a forward contract, while the spot rate is the settlement price of a spot contract. Read Answer >>
  4. Compound interest versus simple interest

    Simple interest is only based on the principal amount of a loan, while compound interest is based on the principal amount ... Read Answer >>
Trading Center