Covered interest arbitrage is a strategy that involves investing in a foreign currency with a higher interest rate and hedging the exchange rate risk with a forward contract. A forward contract is an agreement to buy or sell a currency at a predetermined rate in the future. By doing so, the investor can lock in the current exchange rate and eliminate the uncertainty of future fluctuations.
The idea behind covered interest arbitrage is to exploit the difference between the interest rates of two countries and the forward premium or discount of their currencies. The forward premium or discount is the difference between the spot rate and the forward rate of a currency pair, expressed as a percentage. If the forward rate is higher than the spot rate, the currency is said to trade at a premium; if the forward rate is lower than the spot rate, the currency is said to trade at a discount.
The investor can profit from covered interest arbitrage if the interest rate differential is greater than the forward discount or less than the forward premium. In other words, the investor can earn a higher return by investing in a foreign currency than by investing in the domestic currency, after accounting for the cost of hedging the exchange rate risk.
For example, suppose an investor in the U.S. has $1,000,000 and the following information is given:
- The U.S. interest rate is 2% per year
- The foreign interest rate is 4% per year
- The spot exchange rate is 1.2 USD/EUR
- The forward exchange rate is 1.25 USD/EUR
The investor can either invest the $1,000,000 in the U.S. at 2% or convert it to euros at the spot rate, invest it in the foreign country at 4%, and sell the future value of the euros at the forward rate. The two scenarios are compared below:
- Investing in the U.S.: The future value of the $1,000,000 after one year is $1,020,000
- Investing in the foreign country: The investor can buy 833,333 euros at the spot rate of 1.2 USD/EUR and invest them at 4%. The future value of the euros after one year is 866,667 euros. The investor can sell the euros at the forward rate of 1.25 USD/EUR and receive $1,083,333
The investor can earn an extra $63,333 by using covered interest arbitrage, which is a risk-free profit since the exchange rate risk is hedged by the forward contract.
Basic Theory:
Covered interest arbitrage involves borrowing in a low-interest-rate currency, converting the borrowed amount to a higher-interest-rate currency, and investing the proceeds in interest-bearing securities of that currency. The strategy is “covered” because the investor uses a forward contract to hedge against potential exchange rate movements, ensuring a risk-free return.
Procedures:
- Identify Interest Rate Differentials: Determine the interest rates in the two currencies involved. For this example, let’s consider the interest rate in the United States (USD) and Japan (JPY).
- Borrowing and Converting: Borrow in the low-interest-rate currency (e.g., JPY) and convert it to the high-interest-rate currency (e.g., USD).
- Investing in Securities: Invest the converted amount in interest-bearing securities of the high-interest-rate currency.
- Hedging with Forward Contract: Enter into a forward contract to sell the high-interest-rate currency and buy back the low-interest-rate currency at a future date. This hedges against exchange rate movements.
- Calculate Profit: Calculate the profit or loss by considering interest earned on the investment and the cost of the forward contract.
Scenario:
Let’s assume:
- Interest rate in the USD is 3%.
- Interest rate in the JPY is 0.5%.
- Initial investment: 100,000 JPY.
Excel Calculation:
| Step | Description | Formula | Calculation |
|---|---|---|---|
| 1 | Convert JPY to USD at the spot rate | =InitialInvestment / SpotExchangeRate | =100,000 / 110 |
| 2 | Invest in USD securities | =ConvertedAmount * (1 + USDInterestRate) | =90,909 * (1 + 0.03) |
| 3 | Calculate proceeds after investment | =InvestmentInUSD * (1 + USDInterestRate) | =90,909 * (1 + 0.03) |
| 4 | Hedge with a forward contract | =ProceedsAfterInvestment / ForwardRate | =93,298 / 1.05 |
| 5 | Calculate Profit | =ProceedsAfterForwardContract – InitialInvestmentInJPY | =88,850.47 – 100,000 |
Result:
The calculated profit in this scenario is approximately -11,149.53 JPY. This negative value indicates that the covered interest arbitrage did not result in a profit in this case.
Other Approaches:
- Uncovered Interest Arbitrage: Involves taking a speculative position without using a forward contract to hedge against exchange rate movements.
- Statistical Arbitrage: Utilizes statistical models to identify trading opportunities based on historical data and patterns.
