Covered Interest Arbitrage

Introduction

The foreign exchange (Forex) market is the most liquid market globally. Considering its sheer size, a plethora of strategies are used in forex trading. Nonetheless, it is quite different from conventional stock trading and the strategies deployed here to make profitable trades also vary. Covered interest arbitrage is one such strategy that is most commonly used in forex trading.

Arbitrage is basically a trading strategy that benefits from price differences across various geographies and markets. This enables traders to make profits by buying an asset in one market and selling it in another at a higher price. With that premise, let us move on to covered interest arbitrage.

What is interest arbitrage?

You must be aware that in the stock market price differences are common between the spot market (cash market) and the derivatives market (F&O). A similar phenomenon exists even in interest rates, that is between deposits and lending. The interest rates in different countries are different and this itself presents an arbitrage opportunity to traders.

For example, the interest rates of the USA and the UK are 4.76% and 4% respectively at the time of writing. There is a difference of 0.75% between both, which means that traders can make virtually risk-free profits on their trades. How would that work? Let’s find out.

In the interest arbitrage strategy, a trader converts his monetary investment into the currency of the country offering a higher interest rate and investing the same money in that same country. This effectively means that the trader makes gains by not investing locally and generating higher returns by investing in a different geography.

What is covered interest arbitrage?

Covered interest arbitrage takes the simple interest arbitrage strategy one step forward by also covering the risk involved in currency exchange. To do so, the trader uses forward contracts and hedges the risk associated with fluctuating forex currencies.

In countries within which the exchange of information is fluid, the chance of making a profit is much lower. This is because new information gets priced into the market as quickly as the other nations, thus offering no arbitrage opportunities.

This strategy works only when the following conditions are met, else the realized profits will be minuscule:

• The interest rates environment in the paired countries must be very different.
• The returns made from investing in the high-interest economy must beat the cost of hedging forex risk through the forward contracts.

This will become much clearer if we understand the transactions through an example of covered interest arbitrage:

Let’s say you have ₹1,00,000 and the current interest rate in India is 6.5%. In order to make money you will scout for countries with higher interest rates. Let’s say you choose Russia, where the interest rate is 8.5%.

• To be able to invest in Russia, you will first have to convert your INR to Russian Rubles (symbol is ₽), the exchange for which is 0.93. After conversion, your sum of ₹1,00,000 becomes ₽93,000.
• Now you invest your ₽90,000 in Russia at an 8.5% interest rate for a period of let’s say 1 year. But obviously, you do not know what the exchange rate from Rubles to INR would be after 1 year. So you enter a forward contract, which allows you to exchange Rubles for INR at a rate of ₹1.07/₽ and nullify that exchange rate risk.
• Your investment at the end of 1 year becomes 93,000 x 1.085 = ₽1,00,905. Since you have nullified your exchange rate risk, you are able to convert this entire sum to INR at the current exchange rate of 1.07, which amounts to 1,00,905 x 1.07 = ₹1,07,968.35.

If invested at a 6.5% interest rate in India, your investment would have amounted to ₹1,06,500. So, you not only made a profit of ₹1,478.35 but also mitigated the forex risk through the covered interest arbitrage strategy.

Risks of covered interest arbitrage strategy

No strategy is 100% risk-free and always carries some demerits as well, as is the case here:

• It is possible that geopolitical developments may cause the target currency to collapse, thus leading to a better exchange rate when converting the amount back to your domestic currency. In such a case the forward contract will cause you to pay higher and will also eat away your profits.
• There may even be major events that cause an imbalance between currency supply and demand, which may hinder the conversion between two currencies or even render it impossible.
• Changes in the exchange rate are very likely at the time of conversion into a foreign currency, which is also another cause of reduced profits.
• The tax treatment of gains made through covered interest arbitrage is not exactly defined and varies from country to country. A thorough study of the same is recommended before dabbling in foreign markets.

Conclusion

While this strategy may now have begun to sound simple, market inefficiencies and vulnerabilities may cost you your potential profits at the time of making the actual transaction. The interest rate differential between countries is seldom high enough for such a trade to return more profit than other investment options. However, with that said, a small percentage difference on a large sum is enough to yield sufficiently large returns and may even be profitable if the covered interest arbitrage strategy is used correctly.