Covered interest arbitrage is a strategy used by investors to exploit discrepancies in interest rates between two countries. It is used when there is a disequilibrium between the spot and forward exchange rates or between the domestic and foreign interest rates. This strategy involves borrowing in a country with a lower interest rate, converting the funds to another currency, investing in a country with a higher interest rate, and then converting the funds back to the original currency. The investor profits from the difference between the two interest rates, less any costs associated with the transaction.

Covered interest arbitrage

Covered interest arbitrage it is a arbitration trading strategy in which an investor capitalizes on the interest rate difference between two countries, using a Advanced contract for to cover (eliminate exposure to) cambial risk. The use of forward contracts allows arbitrageurs, such as individual investors or banks to make use of term award (or discount) to make a risk-free profit from the discrepancies between the interest rates of two countries. The risk-free profit opportunity arises from the reality that the interest rate parity condition does not sustain itself constantly. When the spot and forward foreign exchange markets are not in a state of balanceinvestors will no longer be indifferent between the interest rates available in two countries and will invest in either coin offers a bigger return rate. Economists have discovered several factors that affect the occurrence of deviations from covered interest rate parity and the fleeting nature of covered interest arbitrage opportunities, such as different characteristics of activevarying the frequencies of time series data, and the transaction costs associated with arbitrage trading strategies.

Covered interest arbitrage mechanics

A visual representation of a simplified covered interest arbitrage scenario, ignoring compound interest. In this numerical example, the arbitrageur is guaranteed to do better than would be achieved by investing internally.

An arbitrageur executes a covered interest arbitrage strategy by exchanging domestic currency for foreign currency in the current market. spot exchange rate, then investing the foreign currency at the foreign interest rate. Simultaneously, the arbitrageur negotiates a forward contract to sell the value of the future value of the foreign investment on a delivery date consistent with the foreign investment maturity date, to receive national currency in exchange for resources in foreign currency.

For example, per the graph on the right, consider that an investor with $5,000,000 is considering investing abroad using a covered interest arbitrage strategy or investing domestically. The interest rate on dollar deposits is 3.4% in U.Swhile the euro deposit rate is 4.6% in euro area. The current spot exchange rate is $1.2730/€ and the six-month exchange rate is $1.3000/€. For simplicity, the example ignores compound interest. Investing $5,000,000 domestic at 3.4% for six months, ignoring compounding, will result in a future value of $5,085,000. However, exchanging $5,000,000 dollars for euros today, investing those euros at 4.6% for six months, ignoring compounding, and exchanging the future value of euros for dollars at forward exchange rate (on the delivery date negotiated in the forward contract), will result in $5,223,488 USD, which means that investing abroad using covered interest arbitrage is the superior alternative.

Effect of arbitration

If there were no impediments, such as transaction coststo covered interest arbitrage, then any opportunity, however minuscule, to profit from it would be immediately exploited by many financial market participants, and the resulting pressure on domestic and future interest rates and the forward exchange rate premium would cause one or more of them to switch virtually instantly to eliminate the opportunity. Indeed, anticipating such arbitrage leading to such market changes would cause these three variables to fall into line to prevent any arbitrage opportunities from arising in the first place: incipient arbitrage may have the same effect, but sooner, as the actual arbitration. Thus, any evidence of empirical deviations from covered interest parity would have to be explained on the basis of some friction in financial markets.

Evidence for Covered Interest Arbitrage Opportunities

Economists Robert M. Dunn, Jr. and John H. Mutti note that financial markets can generate data inconsistent with interest rate parity, and that cases where significant covered interest arbitrage profits appeared viable were often due to assets that did not share the same perceptions of interest rates. risk. , the potential of double taxation due to different policies and investor concerns about the imposition of exchange controls complicated for the execution of fixed-term contracts. Some covered interest arbitrage opportunities appear to exist when exchange rates and interest rates have been collected for different periods; for example, the use of daily interest rates and daily closing exchange rates can give the illusion that arbitrage profits exist. Economists have suggested a number of other factors to explain the observed deviations from interest rate parity, such as different tax treatment, different risks, government exchange controls, supply or demand inelasticity, transaction costs and time differences between observing and executing arbitrage opportunities. economists Jacob Frenkel and Richard M. Levich investigated the performance of covered interest arbitrage strategies during the 1970s flexible exchange rate regime examining transaction costs and differentials between observing and executing arbitrage opportunities. Using weekly data, they estimated transaction costs and assessed their role in explaining deviations from interest rate parity and found that most deviations could be explained by transaction costs. However, the accommodation of transaction costs does not explain the observed deviations from the parity of covered interest rates between US Treasuries and UK. Frenkel and Levich found that executing such trades resulted only in illusory arbitrage profit opportunities and that, on each execution, the to mean percentage of profit decreased in such a way that there was no statistically significant zero profit gap. Frenkel and Levich concluded that there are no untapped profit opportunities in covered interest arbitrage.

Using a daily spot and USD/JPY exchange rates and same-maturity short-term interest rates in the United States and Japan, economists Johnathan A. Batten and Peter G. Szilagyi analyzed the sensitivity of futures market price differentials to short-term interest rate differentials. deadline. The researchers found evidence of substantial variations in deviations from equilibrium covered interest rate parity attributed to transaction costs and market segmentation. They found that such deviations and arbitrage opportunities significantly decreased almost to the point of being eliminated by the year 2000. Batten and Szilagyi point out that the modern reliance on electronic trading platforms and real-time equilibrium prices seem to explain the removal of the historical scale and scope of covered interest arbitrage opportunities. Further investigation of the deviations revealed a long-term dependency, which is considered consistent with other evidence of long-term temporal dependencies identified in the asset returns of other financial markets including coins, actionsand goods.

Economists Wai-Ming Fong, Giorgio Valente, and Joseph KW Fung examined the relationship of covered interest rate parity arbitrage opportunities with market liquidity and credit risk using a dataset of tick-by-tick spot and forward exchange rates for the hong kong dollar concerning United States dollar. Their empirical analysis demonstrates that positive deviations from covered interest rate parity do indeed offset liquidity and credit risk. After accounting for these risk premiumsresearchers have shown that small residual arbitrage profits accrue only to arbitrators able to negotiate low transaction costs.

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