Currency trading is very different from trading stocks. The vast financial market forex trading allows you to use a variety of strategies to make money from currency movements. Covered interest arbitrage is a popular trading strategy when trading currencies.
This interest arbitrage strategy allows you to reduce the risk of exchange rates between two currencies and also gives you the opportunity to profit from market movements. You may be asking yourself the question, "What is covered interest arbitrage?"
Let's take a quick detour to understand interest arbitrage before we get to the real answer to the question "What is covered interest arbitration?"
The stock exchange has a price differential for the same asset in both the spot (cash market) and derivatives (futures or options) markets. Different countries offer different interest rates in terms of deposit and lending rates. The interest rate in the United States of America currently stands at 0.25% and the rate in the United Kingdom at 0.1%.
This is where the fun begins. Investors can use this difference in interest rates between countries to gain risk-free returns from their investments using an approach called interest arbitrage.
Technically, interest arbitrage is a trading strategy and investment strategy in which an investor converts his investment capital into the currency of a country that has a higher rate of return and invests the money in that country. He would make more if he invested the money in a country with a higher rate of interest than he would if he did so domestically.
This is a crucial point to remember about interest arbitrage. This strategy is subject to exchange rate risk because the exchange rates between currencies change constantly.
Let's say, for example, that the exchange rate was low at the time you converted your investment capital into a foreign currency. You find that the exchange rates have fallen further after you have reaped the benefits of your investment. This is known as an exchange rate risk. It can significantly reduce any benefits you may have gotten from the interest arbitrage strategy. There is a way to reduce this exchange rate risk. This is where covered interest arbitrage comes in.
In simple words, for covered interest arbitrage you use a traditional strategy to arbitrage interest and simultaneously purchase a forward-contract. The forward contract should have an expiry date that coincides with the maturity date for your foreign investment. You can thus lock in the exchange rate price and eliminate the risk of losing your investment.
Let's look at an example to help you better understand the concept. Let's say you have $100,000. Current interest rates in the U.S. are around 3%. You decide to put your money in a country with higher interest rates. The current interest rate in the EU (European Union), is around 4%. So, you decide that your $100,000 should be invested in the EU.
So, you decide that your investment capital should be converted from the U.S. Dollars to Euros. The current USD EUR exchange rate at 0.85 means that you will get 0.85 Euros for every USD. After conversion, your investment capital is EUR85,000 (100,000.x 0.85). Then, you decide to invest EUR85,000 at a rate of 4% in EU for a 1-year period.
You don't know the USD EUR exchange rate in a year so you decide to cancel this risk. To lock in your exchange rate, you enter into a forward contract with an institution. The forward contract's value would be EUR88,000. It could also have a maturity date that corresponds to your investment. The forward contract locks in an exchange rate at 1.20 EUR USD
You receive EUR88,000. This amount you can then exchange for U.S. dollars at the end of your investment tenure. Dollars at a 1.20 exchange rate (EUR USD). This amounts to approximately $106,080. You would only have received ($103,000 if you had $100,000 invested in the U.S. market at a 3% interest rate). You can get a return of about $3,080 by using the covered interest arbitrage.
Although it may sound complex, covered interest arbitrage is one of the best ways to generate a return that is almost as risk-free as possible. A word of caution. This method may not yield as much return as other options due to differences in interest rates between different countries. Institutional investors are making extensive use of this strategy to maximize their returns.