What Is Covered Interest Arbitrage?

Covered interest arbitrage is a currency investment strategy that includes using a forward contract to hedge against exchange rate risk. Covered interest rate arbitrage involves exploiting favorable interest rate differences between currencies by investing in a higher-yielding currency and hedging the exchange rate risk through a 澳洲幸运5官方开奖结果体彩网: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. 

澳洲幸运5官方开奖结果体彩网:Uncovered interest arbitrage is also an investment in in✤terest rate differentials but it omits the protection of a forward currency contract.

Understanding Covered Interest Arbitrage

Covered interest rate arbitrage was once far more common than today. The advent of high-sp🌺eed communications has closed opportunities by turning information asymmetry between currencies into a rare and brief occurrence. When arbitrage opportunities appear, market participants will rush in to exploit them and the resulting demand will quickly redress the imbalance.

An investor undertaking a covered interest arbitrage strategy is making simultaneous 澳洲幸运5官方开奖结果体彩网:spot and forward market transactions, with an ove﷽rall goal of obt⛦aining riskless profit through the combination of currency pairs.

Today's returns on covered interest rate arbitrage tend to be small, especially in markets that are competitive or have relatively low levels of information asymmetry. Users of this strategy now rely on volume to make a substantial profit. A four-cent gain isn't much but it adds up when millions of dollars are involved.

The drawback to this type of strategy is the complexity associated with making si𒊎multaneous transactions across different currencies.

Example of Covered Interest Arbitrage

Forward exchange rates are based on interest rate differentials between two currenciꩲ⛄es.

As an 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. (The forward rate is calculated as [spot rate] times [1.04 / 1.02]).

The difference between the forward rate and sp✤ot rate is known as “swap points,” which in this case amounts to 196 (1.0196 - 1.0000).

ꦛIn𓆉 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. (This example ignores bid/ask spreads for the sake of simplicity).

Covered interest arbitrage, in this case, would only be possible if the cost of hedging is les💞s 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.

Steps to Take

A savvy investor could exploit this arbitrage opportunit🅘y 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.
  

The Bottom Line

✅Covered interest arbitrage removes much of the risk of trading currencies. It involves hedging against adverse changes in the interest rate differential between two currencies. This works, as long as the cost of the hedge does not eat up too much of the profit in the trade.