Covered interest arbitrage is a method of profiting from a favorable set of interest rate conditions in another country. Investors take advantage of the higher interest rate in the second country and hedge against exchange rate risks with forward contracts that guarantee a particular exchange rate at a future date.
This is easiest to illustrate with a fictionalized example.
Let’s say the US interest rate on deposits is 1% and the interest rate on deposits in the People’s Republic of Fictionia is 10%. The exchange rate between the US Dollar and the Fictonian currency, the Snafu, is 1 Dollar = 5 Snafus. You have $100,000 to invest but would like to do better than 1% return giving you $101,000 at the end of the year.
You exchange your $100,000 and receive $500,000 Snafus, which you deposit in the People’s Bank of Fictionia for one year. At the end of that year, with 10% interest you will have $550,000 Snafus to bring back into the US.
Unfortunately, the Snafu is a volatile currency, and it has weakened against the dollar so that the exchange rate at the end of the year is 1 dollar = 5.6 Snafus. Converting your Snafus back into dollars will net you $98,214 – less than the $100,000 you started with. Currency devaluation consumed your profits and then some, not to mention all the transaction fees you paid along the way. This is uncovered interest arbitrage, which worked out poorly for you in this case.
Had you paid a premium to set up a forward currency contract to exchange dollars for 5.3 Snafus at the end of that year, your return would have been $103,773. By paying to hedge against currency devaluation, you managed to make $3,773. Assuming your hedging premium, collective fees, and other costs were less than $2,773, you came out ahead of investing in the US at 1%.
By simultaneously executing a spot market trade (at current exchange rates) and a forward currency contract (paying a premium to guarantee a decent exchange rate in a year), you have “covered” your interest rate arbitrage against currency fluctuations that could wipe out your gains.
Again, this is cartoonishly simplified, and does not take into account tax issues, transaction fees, or bid/ask spreads in the currency exchange, and it assumes that all trades are executed at the listed rate without any slippage. To make a profit, the collective tax and transaction costs plus the premium you pay for the currency hedge has to be less than the profit you will make from the difference in interest rates – and you have to decide whether or not that amount of return is the best use of your money.
This method is still in significant use in major financial markets, but with the instantaneous information flow in today’s market, opportunities for this sort of arbitrage with reasonable margins are rare. Any large differential that can be exploited is usually exploited quickly.
Major players can make their gains through the use of high volumes. A penny’s worth of clear margin may take tens or hundreds of thousands of dollars invested to make the venture worthwhile.
Covered interest arbitrage is not for the beginning investor – you generally need large amounts of investment money available even to consider getting into this trade. However, if you have that much money available – or the guts to borrow that much money and engage in covered interest arbitrage – it is an interesting trading approach. Make certain you have done extensive research in the art, and be sure that you are comfortable with the potential losses you may incur as you learn the ropes. It could turn out to be a much more expensive lesson than this one.