Covered interest arbitrage

Covered interest arbitrage

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.

Example

In this example the investor is based in the United States and assumes the following prices and rates: spot USD/EUR = $1.2000, forward 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 parity 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.

See also


Wikimedia Foundation. 2010.

Игры ⚽ Нужно сделать НИР?

Look at other dictionaries:

  • Covered interest arbitrage — A portfolio manager invests dollars in an instrument denominated in a foreign currency and hedges his resulting foreign exchange risk by selling the proceeds of the investment forward for dollars. The New York Times Financial Glossary …   Financial and business terms

  • covered interest arbitrage — Occurs when a portfolio manager invests dollars in an instrument denominated in a foreign currency and hedges the resulting foreign exchange risk by selling the proceeds of the investment forward for dollars. Bloomberg Financial Dictionary …   Financial and business terms

  • Uncovered interest arbitrage — is a form of arbitrage where funds are transferred abroad to take advantage of higher interest in foreign monetary centers. It involves the conversion of the domestic currency to the foreign currency to make investment; and subsequent re… …   Wikipedia

  • Covered Interest Rate Parity — This term refers to a condition where the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. As a result, there are no interest rate arbitrage opportunities between those two… …   Investment dictionary

  • Uncovered Interest Arbitrage — A form of arbitrage that involves switching from a domestic currency that carries a lower interest rate to a foreign currency that offers a higher rate of interest on deposits. There is a foreign exchange risk implicit in this transaction since… …   Investment dictionary

  • 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.[1] Two assumptions central to interest rate parity are capital mobility and… …   Wikipedia

  • Arbitrage — For the upcoming film, see Arbitrage (film). Not to be confused with Arbitration. In economics and finance, arbitrage (IPA: /ˈɑrbɨtrɑːʒ/) is the practice of taking advantage of a price difference between two or more markets: striking a… …   Wikipedia

  • Triangular arbitrage — (sometimes called triangle arbitrage) refers to taking advantage of a state of imbalance between three foreign exchange markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the… …   Wikipedia

  • Credit card interest — Finance Financial markets Bond market …   Wikipedia

  • Арбитраж — ARBITRAGE Биржевая операция по купле и одновременной продаже товаров, ценных бумаг или иностранной валюты на разных рынках с целью получения прибыли за счет разницы цен на этих рынках. В отличие от спекуляции (см. Speculation), арбитражные… …   Словарь-справочник по экономике

Share the article and excerpts

Direct link
Do a right-click on the link above
and select “Copy Link”