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Trading currency differs greatly from trading company stocks, as you may already be aware. Additionally, because forex trading is a large-scale financial industry, there are many more diverse tactics available to you for making money off of currency fluctuations. The covered interest arbitrage theory is one such trading technique that is most frequently employed when trading currencies.
By using this interest arbitrage approach, you can profit from market fluctuations while also reducing the risk associated with the exchange rate between two currencies. If you’re wondering, “What is covered interest arbitrage parity?” so read on to.
What is covered interest arbitrage?
Covered interest arbitrage is a method in which an investor or trader uses a forward contract to hedge against exchange rate risk. The strategy of investing in a higher-yielding currency by taking advantage of favourable interest rate differentials and hedging the exchange risk using a forward currency contract is known as covered interest rate arbitrage.
The term “arbitrage” refers to the fact that covered interest arbitrage is only feasible if the cost of hedging the exchange risk is lower than the extra return obtained by investing in a higher-yielding currency. One could compare it to unreported interest arbitrage.
How does covered interest arbitrage work?
To better understand how covered interest arbitrage works, let’s look at an example using the Indian rupee (INR) and the US dollar (USD). Let’s say that currently, the interest rate in India is 4%, while in the United States it is 2%. This means that by borrowing INR and investing it in USD, an investor can earn a 2% profit.
Let’s assume that the current exchange rate is 1 USD = 70 INR. The investor borrows 100,000 INR in India and exchanges it for USD 1,429. They then invest this amount in US government bonds with an interest rate of 2%. After one year, the investment will earn a return of USD 28.58.
Now, let’s consider the interest rate in India suddenly increases to 5%, while the US interest rate remains at 2%. This would mean that the value of INR has increased against USD, resulting in a higher exchange rate of 1 USD = 75 INR. The investor then exchanges their USD 1,429 back into INR, earning a return of 107,175 INR. After paying back the initial loan of 100,000 INR and interest of 4%, they are left with a profit of 7,175 INR.
This covered interest arbitrage example illustrates how covered interest arbitrage calculation can generate profits for investors or traders by taking advantage of fluctuations in interest rates and currency values.
Risks of covered interest arbitrage strategy
Despite its perfect logic, interest rate arbitrage is not risk-free. The foreign exchange markets are hazardous since there are inconsistent regulations and tax agreements. In fact, some economists contend that unless transaction costs are lowered to below-market rates, covered interest rate arbitrage remains unprofitable.
Other possible risks include are: –
- Different tax treatment
- Foreign exchange controls
- Inelasticity of demand or supply (inability to alter)
- Transaction costs
- Process slippage (difference in the exchange rate at the time of the transaction)
Factors affecting the covered interest arbitrage strategy
Some of the factors affecting the success of covered interest arbitrage are as follows: –
- Exchange Rate Expectations
Anticipated changes in exchange rates significantly impact covered interest arbitrage. Investors assess future exchange rate movements to gauge the profitability and risk associated with arbitrage transactions.
- Transaction Costs
Transaction costs, including brokerage fees and spreads, can erode profits in covered interest arbitrage. Minimizing transaction costs is essential for maximizing arbitrage gains.
- Market Liquidity
Market liquidity influences the execution of arbitrage transactions. High liquidity ensures efficient trade execution, while low liquidity can hinder arbitrage opportunities and increase transaction costs.
- Regulatory Constraints
Regulatory policies and restrictions affect the feasibility of covered interest arbitrage. Compliance with regulatory requirements is necessary to avoid legal and financial repercussions.
- Political Stability
Political stability is a crucial consideration for arbitrageurs. Political instability can lead to currency volatility, affecting exchange rates and arbitrage profitability.
- Economic Conditions
Economic indicators, like inflation rates and GDP growth, impact currency values and interest rates, thereby influencing covered interest arbitrage opportunities.
Uncovered interest arbitrage
Similar to covered interest arbitrage, uncovered interest arbitrage does not include a forward contract. In uncovered interest arbitrage, an investor places money in a foreign nation that offers higher interest rates. However, an investor is not shielded from foreign exchange risk by a forward or futures contract. As a result, this type of arbitrage carries a higher risk (currency risk).
Covered vs uncovered interest arbitrage?
| Covered Interest Arbitrage | Uncovered Interest Arbitrage |
| Involves the simultaneous purchase of a currency in the spot market and the sale of the same currency in the forward market | Involves borrowing funds in one currency, converting them into another currency, investing in assets denominated in that currency, and then repaying the borrowed funds in the original currency |
| Guarantees a risk-free profit | Involves speculation on the future exchange rate movements |
| Utilizes forward contracts to hedge against exchange rate risk | Does not involve hedging mechanisms |
| Arbitrageurs lock in profits by taking advantage of interest rate differentials between two countries. | Relies solely on interest rate differentials for profit |
| Requires no exposure to exchange rate risk as it involves simultaneous purchasing and selling of currencies | Involves exposure to exchange rate risk as it relies on future exchange rate movements |
| Considered less risky compared to uncovered interest arbitrage | Considered more speculative and riskier than covered interest arbitrage |
| Involves lower potential returns compared to uncovered interest arbitrage | Offers potentially higher returns due to the absence of hedging mechanisms |
The Bottom Line
Covered interest arbitrage is a complex financial strategy that requires careful analysis and execution. While it can offer high potential returns, it also comes with certain risks and challenges. By closely monitoring interest rates, diversifying investments, and effectively hedging, investors can increase their chances of success in this practice. However, it is important also to consider the numerous factors that can impact the effectiveness of covered interest arbitrage before engaging in it.
FAQs
Covered interest arbitrage works by taking advantage of discrepancies in interest rates and currency values between two countries. By borrowing at a low interest rate, exchanging for a higher-interest currency, and investing in profitable financial instruments, investors can earn profits.
Interest rate fluctuations can impact the potential profits of covered interest arbitrage. If there are sudden and unpredictable changes in interest rates, it can affect the effectiveness of the strategy.
Covered interest arbitrage is a financial strategy used by investors to take advantage of differences in interest rates between two countries. It involves borrowing funds at a low interest rate, exchanging them for a higher-interest currency, and then investing the funds in profitable financial instruments.
Some risks associated with covered interest arbitrage include changes in currency values, liquidity risk, and interest rate fluctuations. These factors can impact the profitability of the strategy and result in potential losses.
Diversification is important in covered interest arbitrage as it helps spread out risks across different currencies and countries. By investing in multiple currency pairs, investors can minimise potential losses and increase their chances of success.