Covered interest arbitrage is the name given to an investment strategy. In this strategy an investor buys a financial instrument that is denominated in a foreign currency, and by selling a forward contract in the amount of the proceeds of the investment back into his base currency, he hedges his foreign exchange risk. If the financial instrument is risk-free and only pays interest once, on the date of the forward sale of foreign currency, then only the proceeds of the investment are known exactly. Otherwise, some foreign exchange risk still remains there.
Traders can also make similar trades using risky foreign currency bonds or even foreign stock, but the risk may be added to the transaction by hedging trades, for instance, in case if the bond defaults then the investor may lose on both the bond and the forward contract.
Example
In this example the investor is based in the United States and following prices and rates are assumed by him: spot USD/EUR = $1.2000, forward USD/EUR for 1 year delivery = $1.2300, dollar interest rate = 4.0%, euro interest rate = 2.5%.
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He exchange USD 1,200,000 into EUR 1,000,000
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He buys EUR 1,000,000 worth of euro-denominated bonds
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He sell EUR 1,025,000 via a 1 year forward contract, in order to receive USD 1,260,750, i.e. he is agreed to exchange the euros back into US dollars in 1 year at today’s forward price.
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Two transactions occur consecutively, at the expiry of one year. First transaction is that, the euro-denominated bond delivers EUR 1,025,000. Second transaction is that, the forward contract turns the EUR 1,025,000 into USD 1,260,750. So, the earning is USD 60,750. If the investment had been made in dollar, the return would have been only 4%. But, in this case, you can see yourself that the two transactions results in an effective dollar interest rate of (1,260,750/1,200,000)-1 = 5.1%
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In the above discussion the cost of capital has not been considered. Alternatively, if the USD 1,200,000 were borrowed at 4%, in 1 year USD 1,248,000 would be owed, which gives an arbitrage profit of 1,260,750 – 1,248,000 = USD 12,750 in a year.
Models
It has been assumed by the financial models such as interest rate parity and the cost of carry model that no such arbitrage profits could exist in equilibrium, thus for risk-free instruments the effective dollar interest rate of investing in any currency will equal the effective dollar rate for any other currency.
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Posted by R. MAK. in Currency Trade, Forex Basics, Forex Market · 0 Comment
