Coveredinterest arbitrage

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Covered-interest arbitrage is the movement of short-term funds between countries to take advantage of interest differentials with exchange risk covered by forward contracts. When investors purchase the currency of a foreign country to take advantage of higher interest rates abroad, they must also consider any losses or gains. Such losses or gains might occur due to fluctuations in the value of the foreign currency prior to the maturity of their investment. Generally, investors cover against such potential losses by contracting for the future sale or purchase of a foreign currency in the forward market.

Their actions, aimed at profits from interest rate differentials between countries, lead, in equilibrium, to the condition of so-called interest parity. The interest rate parity theory says that any exchange gains or losses incurred by a simultaneous purchase and sale in the spot and forward markets are offset by the interest rate differential on similar assets. Under these conditions, there is no incentive for capital to move in either direction, because the effective returns on foreign and domestic assets have been equalized.

Figure 5.5 presents a graphic representation of the theoretical relationship between the forward premium or discount and the interest rate differential. The vertical axis represents the interest differential in favor of the foreign currency and the horizontal axis shows the forward premium or discount on that currency. The interest parity line shows the equilibrium state. This chapter ignores transaction costs for simplicity. However, it is important to recognize the fact that transaction costs cause the interest parity line to be a band rather than a thin line. Transaction costs include the foreign-exchange brokerage costs on spot and forward contracts as well as the investment brokerage cost on buying and selling securities.

Point A of figure 5.5 shows that the forward discount for foreign exchange is 1 percent and that the foreign interest rate is 2 percent higher than the domestic interest rate. In this case, the arbitrageur could employ the so-called covered-interest arbitrage to make a profit. Specifically, the arbitrageur would earn 2 percent more on her investment in foreign securities and lose 1 percent on the repurchase of the domestic currency in the forward market by taking the following actions: (1) buying spot foreign currency with domestic currency; (2) investing the foreign currency in foreign securities; and (3) selling the foreign currency in the forward market. The net result is that the arbitrageur would make a profit of 1 percent from this covered-interest arbitrage transaction.

The arbitrageur would have to convert the foreign currency to domestic currency at the end of maturity. The exchange rate may fall before the arbitrageur has returned her funds to her home country. For that reason, the arbitrage transaction involves foreign-exchange risks. To avoid these risks, she will cover the transaction by selling forward the same amount of the foreign currency at 1 percent discount. The investment protected by forward sales is called covered-interest arbitrage.

Interest differential in favor of foreign currency in percent per year

Interest differential in favor of foreign currency in percent per year

Forward premium or discount in percent per year

Figure 5.5 Covered-interest arbitrage

Forward premium or discount in percent per year

Figure 5.5 Covered-interest arbitrage

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