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 arbitrage is 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.
Basics of 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. Part of the reason for this is the advent of modern communications technology. Research indicates that covered interest arbitrage was significantly higher between GBP and USD during the gold standard period due to slower information flows.
While the percentage gains have become 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.
- Covered interest arbitrage uses a strategy of arbitraging the interest rate differentials between spot and forward contract markets in order to hedge interest rate risk in currency markets.
- This form of arbitrage is complex and offers low returns on a per trade basis. But trade volumes have the potential to inflate returns.
Example of Covered Interest Arbitrage
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%. Therefore, the one-year forward rate for this currency pair is 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.