Covered interest arbitrage: Explained | TIOmarkets
BY TIO Staff
|July 4, 2024Covered interest arbitrage is a financial strategy that traders use to exploit differences in interest rates between two countries. By using this strategy, a trader can make a risk-free profit, assuming that there is no foreign exchange risk. The strategy involves borrowing in a country with a lower interest rate, converting the funds into a currency of a country with a higher interest rate, and investing the funds in the higher interest rate country. The trader then uses a forward contract to convert the funds back into the original currency at the end of the investment period.
This strategy is called "covered" because the foreign exchange risk is eliminated by the use of a forward contract. The forward contract locks in the exchange rate at which the funds will be converted back into the original currency. This ensures that the trader knows exactly how much profit they will make from the strategy, regardless of any changes in the exchange rate during the investment period.
Understanding Covered Interest Arbitrage
Covered interest arbitrage is based on the concept of interest rate parity, which states that the difference in interest rates between two countries is equal to the difference between the forward exchange rate and the spot exchange rate. If this parity does not hold, then there is an opportunity for arbitrage.
The strategy involves four steps. First, the trader borrows in a currency with a lower interest rate. Second, the trader converts the borrowed funds into a currency with a higher interest rate. Third, the trader invests the funds in a financial instrument that pays interest in the higher interest rate currency. Finally, the trader enters into a forward contract to convert the funds back into the original currency at the end of the investment period.
Step 1: Borrowing
The first step in covered interest arbitrage is to borrow in a currency with a lower interest rate. The trader borrows as much as they can, because the more they borrow, the more profit they can make. The borrowed funds are then converted into the currency of the country with the higher interest rate.
The borrowing is typically done through a loan or a bond issuance. The trader must ensure that the cost of borrowing is less than the expected return from the investment in the higher interest rate country. If the cost of borrowing is higher, then the strategy will not be profitable.
Step 2: Conversion
The second step is to convert the borrowed funds into the currency of the country with the higher interest rate. This is done using the spot exchange rate, which is the current exchange rate. The trader must ensure that the exchange rate is favorable, otherwise the strategy will not be profitable.
The conversion is typically done through a foreign exchange market, where currencies are bought and sold. The trader must be careful to avoid any fees or commissions that could reduce the profitability of the strategy.
Investing and Forward Contract
Once the funds have been converted into the higher interest rate currency, the trader then invests the funds in a financial instrument that pays interest in that currency. This could be a bond, a deposit account, or any other investment that pays a fixed rate of return. The trader must ensure that the return on the investment is higher than the cost of borrowing, otherwise the strategy will not be profitable.
The final step in the strategy is to enter into a forward contract to convert the funds back into the original currency at the end of the investment period. The forward contract locks in the exchange rate at which the funds will be converted back, eliminating any foreign exchange risk. This ensures that the trader knows exactly how much profit they will make from the strategy, regardless of any changes in the exchange rate during the investment period.
Step 3: Investing
The third step in covered interest arbitrage is to invest the converted funds in a financial instrument that pays interest in the higher interest rate currency. The choice of investment will depend on the interest rates available, the risk profile of the investor, and the term of the investment.
The investment is typically made in a bond or a deposit account, but it could also be made in any other financial instrument that pays a fixed rate of return. The trader must ensure that the return on the investment is higher than the cost of borrowing, otherwise the strategy will not be profitable.
Step 4: Forward Contract
The final step in covered interest arbitrage is to enter into a forward contract to convert the funds back into the original currency at the end of the investment period. The forward contract locks in the exchange rate at which the funds will be converted back, eliminating any foreign exchange risk.
The forward contract is typically arranged at the same time as the borrowing and conversion steps. The trader must ensure that the forward exchange rate is favorable, otherwise the strategy will not be profitable. The forward exchange rate is determined by the interest rate differential between the two countries, and it is typically quoted for specific dates in the future.
Risks and Limitations
While covered interest arbitrage is a risk-free strategy in theory, in practice there are several risks and limitations that traders must be aware of. These include credit risk, liquidity risk, and operational risk.
Credit risk is the risk that the borrower will default on the loan or the bond issuer will default on the bond payments. Liquidity risk is the risk that the trader will not be able to convert the funds back into the original currency at the end of the investment period. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.
Credit Risk
Credit risk is the risk that the borrower will default on the loan or the bond issuer will default on the bond payments. This risk can be mitigated by only borrowing from or investing in reputable institutions, and by diversifying the investments across different issuers.
However, even with these precautions, credit risk cannot be completely eliminated. If the borrower or issuer defaults, the trader could lose all or part of their investment. This is why it is important for traders to thoroughly research the creditworthiness of the borrower or issuer before engaging in covered interest arbitrage.
Liquidity Risk
Liquidity risk is the risk that the trader will not be able to convert the funds back into the original currency at the end of the investment period. This could happen if the foreign exchange market is illiquid, or if the forward contract counterparty defaults.
This risk can be mitigated by only trading in liquid markets, and by using reputable counterparties for the forward contracts. However, even with these precautions, liquidity risk cannot be completely eliminated. If the trader is unable to convert the funds back, they could be stuck with a large amount of foreign currency that they cannot use or exchange.
Operational Risk
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This includes risks related to technology, compliance, and human error.
This risk can be mitigated by having robust systems and processes in place, by training staff properly, and by complying with all relevant regulations. However, even with these precautions, operational risk cannot be completely eliminated. If a mistake is made, or if a system fails, the trader could lose all or part of their investment.
Conclusion
Covered interest arbitrage is a financial strategy that traders use to exploit differences in interest rates between two countries. While the strategy is theoretically risk-free, in practice there are several risks and limitations that traders must be aware of. These include credit risk, liquidity risk, and operational risk.
Despite these risks, covered interest arbitrage can be a profitable strategy for traders who understand the mechanics of the strategy and who are able to manage the risks effectively. As with any trading strategy, it is important for traders to do their own research and to understand the risks before engaging in covered interest arbitrage.
Start Your Covered Interest Arbitrage Journey with TIOmarkets
Ready to put your knowledge of covered interest arbitrage into action? Join TIOmarkets, the top-rated forex broker, and trade over 300 instruments across 5 markets with low fees. With over 170,000 accounts opened in more than 170 countries, we're committed to helping you trade effectively. Benefit from our comprehensive educational resources and step-by-step guides designed to enhance your trading skills. Create a Trading Account today and start exploring the potential of covered interest arbitrage.
Risk disclaimer: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money. Never deposit more than you are prepared to lose. Professional client’s losses can exceed their deposit. Please see our risk warning policy and seek independent professional advice if you do not fully understand. This information is not directed or intended for distribution to or use by residents of certain countries/jurisdictions including, but not limited to, USA & OFAC. The Company holds the right to alter the aforementioned list of countries at its own discretion.
Join us on social media
Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.
Trade responsibly: CFDs are complex instruments and come with a high risk of losing all your invested capital due to leverage.
These products are not suitable for all investors and you should ensure that you understand the risks involved.