What is: Covered Interest Arbitrage

What is Covered Interest Arbitrage?

Covered interest arbitrage is a strategy used by investors to take advantage of the interest rate differentials between two countries. This strategy involves borrowing money in a country with a low interest rate and investing it in a country with a higher interest rate. By using forward contracts to hedge against exchange rate risk, investors can lock in a profit without taking on any additional risk.

How Does Covered Interest Arbitrage Work?

In covered interest arbitrage, investors borrow money in a currency with a low interest rate, such as the US dollar, and then convert it into a currency with a higher interest rate, such as the British pound. They then invest the borrowed money in high-yielding assets in the foreign currency, while simultaneously entering into a forward contract to sell the foreign currency at a predetermined exchange rate.

Benefits of Covered Interest Arbitrage

One of the main benefits of covered interest arbitrage is that it allows investors to profit from interest rate differentials without taking on any additional risk. By using forward contracts to hedge against exchange rate fluctuations, investors can lock in a guaranteed profit regardless of how the exchange rate moves.

Risks of Covered Interest Arbitrage

While covered interest arbitrage is generally considered to be a low-risk strategy, there are still some risks involved. One of the main risks is that the exchange rate may move against the investor, resulting in a loss on the investment. Additionally, there is always the risk that the forward contract may not be honored, leading to potential losses.

Example of Covered Interest Arbitrage

For example, let’s say an investor borrows $1 million in the US at an interest rate of 1% and converts it into British pounds at an exchange rate of 1.3. They then invest the £769,231 in UK government bonds yielding 2%. At the same time, they enter into a forward contract to sell the pounds back to dollars at an exchange rate of 1.4. This would result in a guaranteed profit of $30,769, regardless of how the exchange rate moves.

Conclusion

Covered interest arbitrage is a powerful strategy that allows investors to profit from interest rate differentials without taking on any additional risk. By using forward contracts to hedge against exchange rate fluctuations, investors can lock in a guaranteed profit regardless of how the market moves.