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Covered interest arbitrage is a financial strategy intended to minimize a foreign investment's risk. When the rate of return on a secure investment is higher in a foreign market, an investor might convert an amount of currency at today's exchange rate to invest there. At the same time, the investor would sell a contract in the amount of the investment, plus its expected return, back into his or her home currency. This contract, called a forward contract, locks in a future currency conversion rate and removes the risk associated with exchange rate changes. The return on the investment must be paid in full on the same date as the forward currency sale for this strategy to be effective.
If the same investment was made uncovered, a declining currency value for the country of investment could erode expected profits. There is also the possibility that a more favorable exchange rate might exist at the time of the investment's payout. It is generally considered more prudent, however, to lock in a guaranteed rate of return than to accept unnecessary risk in hopes of a higher rate.
Those engaging in covered interest arbitrage typically look for certain disparities between markets to exploit. One is the difference between the current, or spot, rate of exchange between two currencies and the forward rate. Another is the difference in the interest rates between two countries.
In general, there is opportunity to make a profit from covered interest arbitrage in one of two scenarios. In the first, the interest rate differential between two countries is less than the difference between the spot and forward exchange rates expressed as a percentage of the forward rate. In this situation an investor should borrow money in the country with the higher interest rate, and invest it in the country with the lower interest rate.
In the second scenario, the interest differential is greater than the difference between the spot and forward exchange rates written as a percentage of the forward rate. An investor seeing this situation should borrow in the country with the lower interest rate and invest the money in the country with the higher interest rate. In either scenario, the profit would be the amount invested, plus the return, less the amount borrowed, plus the amount of interest.
In a condition of interest rate parity, variations in exchange and interest rates offset. Returns from domestic and foreign investment in the same financial instrument would be equivalent. When this condition exists, an arbitrage-free investing environment prevails. There is no benefit to be gained from investing in foreign markets and no reason to practice covered interest arbitrage.
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