Uncovered Interest Arbitrage

What Is Uncovered Interest Arbitrage?

Uncovered interest arbitrage is a form of arbitrage that includes switching from a domestic currency that conveys a lower interest rate to a foreign currency that offers a higher rate of interest on deposits. With uncovered interest arbitrage, there is a foreign exchange risk implicit in this transaction since the investor or speculator should change over the foreign currency deposit proceeds once more into the domestic currency soon.

The term "uncovered" in this arbitrage alludes to the way that this foreign exchange risk isn't covered through a forward or futures contract.

How Uncovered Interest Arbitrage Works

Uncovered interest arbitrage includes an unhedged exchange of currencies with an end goal to earn higher returns due to an interest rate differential between the two currencies. Total returns from uncovered interest arbitrage rely significantly upon currency changes since adverse currency developments can clear out every one of the gains and as a matter of fact even lead to negative returns. On the off chance that the interest rate differential got 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%. Then again, assuming the foreign currency deteriorates by 4% during the holding period, the total return is - 1%.

Features

• The term "uncovered" in this arbitrage alludes to the way that this foreign exchange risk isn't covered through a forward or futures contract.
• Uncovered interest arbitrage includes an unhedged exchange of currencies with an end goal to earn higher returns due to an interest rate differential between the two currencies.
• Uncovered interest arbitrage is a form of arbitrage that includes switching from a domestic currency that conveys a lower interest rate to a foreign currency that offers a higher rate of interest on deposits.