Covered Interest Arbitrage
What Is Covered Interest Arbitrage?
Covered interest arbitrage is a strategy where an investor utilizes a forward contract to hedge against exchange rate risk. Covered interest rate arbitrage is the practice of utilizing positive interest rate differentials to invest in a higher-yielding currency, and hedging the exchange risk through a forward currency contract.
Covered interest arbitrage is just conceivable in the event that the cost of hedging the exchange risk is not exactly the unexpected return generated by investing in a higher-yielding currency — subsequently, the word arbitrage. It might be stood out from uncovered interest arbitrage.
Rudiments of Covered Interest Arbitrage
Returns on covered interest rate arbitrage will generally be small, particularly in markets that are competitive or with moderately low levels of information deviation. Part of the justification for this is the appearance of modern communications technology. Research shows that covered interest arbitrage was fundamentally higher among 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 thought about. A four-penny gain for $100 isn't a lot yet looks much better when a great many dollars are involved. The drawback to this type of strategy is the complexity associated with making simultaneous transactions across various currencies.
Such arbitrage opportunities are phenomenal, since market participants will rush in to take advantage of an arbitrage opportunity on the off chance that one exists, and the resultant demand will rapidly review the imbalance. An investor undertaking this strategy is making simultaneous spot and forward market transactions, with an overall goal of getting risk-less profit through the combination of currency pairs.
Illustration of Covered Interest Arbitrage
Note that forward exchange rates depend on interest rate differentials between two currencies. As a simple model, expect 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%. Subsequently, the one-year forward rate for this currency pair is X = 1.0196 Y (without getting into the specific 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). By and large, a currency with a lower interest rate will trade at a forward premium to a currency with a higher interest rate. As should be visible in the above model, X and Y are trading at parity in the spot market, yet in the one-year forward market, every unit of X brings 1.0196 Y (overlooking bid/ask spreads for simplicity).
Covered interest arbitrage in this case would possibly be conceivable if the cost of hedging is not exactly the interest rate differential. We should expect the swap points required to buy X in the forward market one year from now are just 125 (as opposed to the still up in the air by interest rate differentials). This means that the one-year forward rate for X and Y is X = 1.0125 Y.
A canny investor could consequently take advantage of this arbitrage opportunity as follows:
- Borrow 500,000 of currency X @ 2% per annum, and that means that the total loan repayment obligation following a year would be 510,000 X.
- Convert the 500,000 X into Y (since 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 go into a forward contract that changes over 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.
- Following 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.
- These opportunities depend on the principle of covered interest rate parity.
- This form of arbitrage is complex and offers low returns on a for every trade basis. However, trade volumes can possibly expand returns.
- Covered interest arbitrage utilizes a strategy of arbitraging the interest rate differentials among spot and forward contract markets to hedge interest rate risk in currency markets.