Covered interest arbitrage is an arbitrage trading strategy. Through the strategy, investors utilize the differential in the interest rates of the two countries. And, to mitigate the exchange rate risk, they use a forward contract.
Since it’s an arbitrage, so the authorized dealers (in the foreign exchange market) would try to quickly utilize any such opportunity and their actions would bring things to the equilibrium. And, when things are in equilibrium, investors may not be able to utilize the strategy.
Covered interest arbitrage example
Understand it better through an example. Let’s say an investor has the option to either invest in USD or EURO.
For USD investments, assume that the fixed interest rate we get is 5 percent per annum. And, markets quote Dollar against Euro at $1.07 in spot and $.93 for an annual forward contract. And, if we invest €100,000 in US Dollars. Then, in one year our investment would be ((100,000*1.07)+5350)*0.93 = €104,485.5
By selling a forward contract, we try to mitigate the exchange rate risk. We know that exchange rate markets can be quite volatile. And, we would want to lock in the amount we have to pay one year from now.
And, compare it with his/her EURO investments that yield a fixed interest rate. Let’s say at a fixed interest rate of 3.5 percent per annum, then a year later it would be €103,500. So, it is better to utilize covered interest arbitrage opportunities.
One can borrow funds to utilize the interest rate differential. If we continue with the above example. And, assume that the investor had to borrow €100,000 at 4 percent per annum. Then, by investing in US Dollars, the investor earns a profit of €485.50.
In conclusion, covered interest arbitrage is a strategy that an investor can utilize to capitalize on inefficiencies in the market.
Important: This material is provided only for information purposes only. It doesn’t constitute investment advice. We shouldn’t be held liable for the investment decisions readers take. We encourage readers to act at their discretion.
