Covered Interest Arbitrage

If you decide to invest some money in a foreign financial instrument, what do you need to do? First, you need to obtain some foreign currency and then invest it in the desired financial instrument. We call this as taking a long position.

What would you do when the foreign instrument matures? Obviously, you will convert the proceeds back to your own currency to see if you made a profit.

You will realize that this can involve exchange - rate risk because by the time the foreign instrument matures, the exchange rate might have moved against you. For example, if the foreign currency has depreciated in the mean time, you will get lesser units of the home currency when you convert your earnings from the financial instrument.

What can be done to hedge this risk?

The answer is simple. You go ahead and take a short position by entering into a matching forward contract.

For example, if you invested in a short - term financial instrument in the Euro - Zone at a time when the exchange rate was 1 Euro / $ and if you expect your foreign earnings to be 200 Euros (assuming your home currency is the US dollar), you will want to make sure that even if the euro depreciates against the dollar, you do not lose on that account. If the Euro depreciated to Euro 0.8 / $ by the time your investment matured, you will get only 200 x 0.8 = $160 upon conversion. To prevent that from happening, you can enter into a forward contract to sell Euros at a pre - specified exchange rate, say Euro 0.95 / $, thereby locking in the rate at which your Euros will be converted into dollars. No matter what happens to the exchange rate in the spot market now, you can be assured of receiving 200 x 0.95 = $190 at maturity.

This process is known as covered interest arbitrage. What acts as a cover? The forward rate of exchange pre - specified in the forward contract. If you did not use a forward contract, your position would remain uncovered and you will have to bear the exchange - rate risk.

It follows that when your arbitrage is covered, you are shielded from FOREX fluctuations and that means even if the exchange rate moves in your favor, you can not take advantage of that. When you remain uncovered, you assume the exchange - rate risk but the up side is that you remain available for any favorable exchange rate movement.

Higher risk can translate into a higher return. It is as simple as that.

The question arises as to why someone would want to invest in a foreign financial instrument after all. The answer is pretty simple. If you can fetch a better return abroad, you go there, provided that  the extra return is not eroded by currency conversion.

Is there something that can discourage you from doing so? Yes. You will not be interested if whatever extra you earn is lost in converting your money from one to the other currency. Or if you  can get a similar return on a domestic financial instrument, you will not take the trouble of going abroad with your money. When will this happen? When the Interest Rate Parity (IRP) condition holds. When it holds, then the difference in national interest rates for similar securities is equal (but opposite in sign) to the forward premium or discount on the foreign currency. So, whatever you gain through the interest rate differential is offset by the premium or discount on the foreign currency.

The following video demonstrates this process:

For a foreign exchange trader, no particular country is the home country. (S)he will invest in whichever currency offers a higher return on a covered basis.

For deciding which currency to start the arbitrage process from, we take the following steps:

1. Compute the annualized forward premium / discount on the foreign currency
2. Compute absolute annual interest rate differential between the countries concerned
3. If the interest rate differential is less than the forward premium / discount, borrow in the higher interest rate country and invest in the lower interest rate country and vice - versa.

The following video gives a brief demo of this process. In the last step (where arbitrage profit is computed), I have said $116.67 - 100, whereas it should be $116.67 - 110 [Slip of tongue :)]. Please be guided accordingly.