Covered interest arbitrage
Encyclopedia
Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency
, and hedges
his foreign exchange risk by selling a forward contract
in the amount of the proceeds of the investment back into his base currency. The proceeds of the investment are only known exactly if the financial instrument is risk-free and only pays interest once, on the date of the forward sale of foreign currency. Otherwise, some foreign exchange risk remains.
Similar trades using risky foreign currency bonds or even foreign stock may be made, but the hedging trades may actually add risk to the transaction, e.g. if the bond defaults the investor may lose on both the bond and the forward contract.
USD/EUR = $1.2000, forward
USD/EUR for 1 year delivery = $1.2300, dollar interest rate = 4.0%, euro interest rate = 2.5%.
and the cost of carry
model assume that no such arbitrage profits could exist in equilibrium, thus the effective dollar interest rate of investing in any currency will equal the effective dollar rate for any other currency, for risk-free instruments.
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
, and hedges
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
his foreign exchange risk by selling a forward contract
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
in the amount of the proceeds of the investment back into his base currency. The proceeds of the investment are only known exactly if the financial instrument is risk-free and only pays interest once, on the date of the forward sale of foreign currency. Otherwise, some foreign exchange risk remains.
Similar trades using risky foreign currency bonds or even foreign stock may be made, but the hedging trades may actually add risk to the transaction, e.g. if the bond defaults 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 assumes the following prices and rates: spotForeign exchange spot trading
A spot foreign exchange transaction, also known as FX spot, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date...
USD/EUR = $1.2000, forward
Forward contract
In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a...
USD/EUR for 1 year delivery = $1.2300, dollar interest rate = 4.0%, euro interest rate = 2.5%.
- Exchange USD 1,200,000 into EUR 1,000,000
- Buy EUR 1,000,000 worth of euro-denominated bonds
- Sell EUR 1,025,000 via a 1 year forward contract, to receive USD 1,260,750, i.e. agree to exchange the euros back into US dollars in 1 year at today's forward price.
- At the expiry of one year, two transactions occur consecutively. First, the euro-denominated bond delivers EUR 1,025,000. Secondly, the forward contract turns the EUR 1,025,000 into USD 1,260,750. So, the earning is USD 60,750. Had the investment been made in dollar, the return would have been only 4%. But, in this case, the two transactions can be viewed as resulting in an effective dollar interest rate of (1,260,750/1,200,000)-1 = 5.1%
- The above discussion does not consider the cost of capital. Alternatively, if the USD 1,200,000 were borrowed at 4%, USD 1,248,000 would be owed in 1 year, leaving an arbitrage profit of 1,260,750 - 1,248,000 = USD 12,750 in 1 year.
Models
Financial models such as interest rate parityInterest rate parity
Interest rate parity is a no-arbitrage condition representing an equilibrium state under which investors will be indifferent to interest rates available on bank deposits in two countries. Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic...
and the cost of carry
Cost of carry
The cost of carry is the cost of "carrying" or holding a position. If long, the cost of carry is the cost of interest paid on a margin account. Conversely, if short, the cost of carry is the cost of paying dividends, or rather the opportunity cost; the cost of purchasing a particular security...
model assume that no such arbitrage profits could exist in equilibrium, thus the effective dollar interest rate of investing in any currency will equal the effective dollar rate for any other currency, for risk-free instruments.