COVERED INTEREST ARBITRAGE

Covered Interest Arbitrage is basically the movement of the short terms funds between two countries for taking the advantage of the interest rate differences along with exchange risks which are covered by the forward contracts. The investors when purchases the foreign currency to take the profit from the interest rate differentials then he must always be ready to take the risks of the fluctuations in the foreign currency and the losses due to it. These losses or gains primarily occur due to the movement of the foreign currency or the fluctuations in the currency. To cover the same or to hedge themselves from these losses the investor does that he equalizes the entire transaction with the purchase or sale of the foreign currency in the forward market, and this leads to hedging and now whatever may be the fluctuations, whatever may be the differences in the interest rates and the currency rates, the investors profit and losses are now hedged and it would be the same, though there are huge differences in the market. Thats why it is called covered since it covers the future uncertainty.

The Interest Rate Parity theory suggests that any amount of exchange gains and losses incurred by the investor by simultaneously purchasing and selling in the spot and the forward markets, are generally offset by the interest rates differences on the similar type of assets. Under the said condition there is basically no incentive for the amount or capital to move in either direction because the total effective returns in the domestic market and the foreign market has equalized or came to equilibrium. Basically, this theory says that whenever there are differences in the forward and the spot rates with the differences in the interest rates between the two countries an arbitrage is possible and the covering of this sort of Arbitrage is referred to as Covered Interest Arbitrage. An arbitrageur would do the following: He would borrow in foreign currency, convert receipts to domestic currency at the prevailing spot rate, and invest in domestic currency denominated securities (as domestic securities carry higher interest). At the same time he would cover his principal and interest from this investment at the forward rate. At maturity, he would convert the proceeds of the domestic investment at prefixed domestic forward rate and payoff the foreign liability. The difference between the receipts and payments serve as profit to customer.So, to get the idea of covered interest Arbitrage the following steps are essential.1. Firstly, the investor has to borrow the currency which as per the Interest Rate Parity has the lower interest rates.

2. After borrowing the currency having the lower interest rates, one has to calculate the payables at the end of the maturity period due to this borrowing.

3. Again now the amount which has been borrowed has to be converted in the other currency; it means that the borrowed amount shall be converted into the other currency.

4. Now you have to lock in at the forward rate as if you can convert back the currency.

5. Now, the converted amount of the currency has to be invested in the prevailing interest rates, obviously it is such that the interest rates are higher at the time of investing in the other currency.

6. After the investment process is done, we have to calculate the amount of the receivables after the maturity of the investments basically in the higher interest rates. Then we have to convert the receivables realized in the currency in which the borrowing has been made using the forward market which was locked to calculate the amount of gain or losses.

7. Now we have to compare the step 2, (here the payables where calculated on maturity) and step 6, (here the receivables are calculated) and we would see that the amount received in step 6 would be higher than the amount received in step 2.This is basically what we refer to as a Covered Interest Arbitrage as all the conditions were fixed at the time of making the borrowings and in there are favorable fluctuations in the market then the investor can enjoy much more gains due to this. But factually, this fluctuation is for splits of time because a large number of investor comes to take the profit margin and then the interest rates and the currency rates comes to equilibrium, decreasing the arbitrage to a no arbitrage situation.Example: If the borrowing rate (interest) in Japan is only 3% and Bangladesh governments saving bonds pay 13.25% annual interest and one year forward rate between Yen and taka is1.11 taka per yen which is currently on the spot exchanging for 1.04 BDT per yen. Can you conduct a covered interest arbitrage?

Before conducting an arbitrage we have to check whether it holds the IRP theory or not. According to IRP the interest rate differentials between Japan and Bangladesh is 10.25% whereas the yen is selling for 6.73% premium only which should have been more than 10% to maintain the IRP. So a covered interest arbitrage is possible. Here are the 7 steps below:

Step 1: The investor has to borrow yen at 3%. Say he/she borrowed 1 million yen at 3% from a Japanese bank since it offers the lower interest rate.

Step 2: Now he/she has to calculate the payable after 1 year which is 1.03 million yen.

Step 3: Now the 1 million yen has to be converted at the spot rate of 1.04 BDT per 1 yen which will be 1.04 million BDT.

Step 4: Now this 1.04 million BDT is invested at risk free Bangladesh governments savings bond at 13.25% interest rate per year.

Step 5: After 1 year the investor will receive 1.1778 million BDT including interest.

Step 6: This 1.1778 million BDT has to be converted to Japanese yen which was locked using the one year forward market at 1.11 BDT per yen which will give 1.061081 million yen.

Step 7: The arbitrageur will make (1.06081 1.03) million or 0.03081 million yen after paying his 1.03 million yen payable to the Japanese bank.

Another example:

$ Interest rate = 2% for 90 days in US. Interest rate = 3% for 90 days in UK

Spot $/ = 1.50 90 day forward $/ = 1.50

Arbitrageur does the following:

Step I Borrow $1.50 million in US for 90 days.

Step II Calculate the payable after 90 daysStep III Convert to at the prevailing spot rate Le. 1.50 to get 1 million

Step IV Buy 90 days Deposit at UK Bank yielding 3% for 90 days.

Step V Sell 1.03 million forward [1 million + 0.03 million interest on deposit] at forward rate of 1.50 per .

Step VI At maturity he gets 1.03 million

Step VII Against his forward contract selling which he has booked he would get

707 __________________________________________

1.50 1.03 = $1.545 million dollars.

Compare this with 1.50 1.02= $1.530 million dollars he would have got by depositing directly in US deposits. Thus he made a profit of $1.545 $1.530 = 0.015 million dollars i.e. $15000.

Uncovered arbitrage is much the same, except that at the start they do not enter into a contract for a forward exchange rate back, meaning that they just have to invest back at the spot rate that is available to them at the end of the year long investment. This is no-where near as safe, but contrary to this there is a chance that the spot exchange rate at the end may be considerably higher or lower depending upon the market at the time and therefore meaning that an uncovered arbitrage may end up making you considerably more money, or the exact opposite.

[Note: Whether the term could be used as uncovered interest arbitrage since arbitrage means riskless profit and with the uncovered interest arbitrage method there is no guarantee a profit will be made and there is also risk involved since not knowing the future spot rate at the time of investment. On the BDT and yen example if the investor didnt buy the forward contract of yen which is selling at 6.73% premium he/she would be uncovered which means the BDT could be exchanged against yen at any rate and thus he/she is exposed to currency risk and if it is exchanged for 1.25 BDT per yen then the investor will incur a significant amount of loss.]

Still lets examine what is an uncovered interest arbitrage. Uncovered interest arbitrage is the notion that the forward exchange rate is an unbiased estimate of the future spot rate.

Uncovered interest arbitrage assumes that, on average, an investor who borrows in a low interest rate country, converts the funds to the currency of a high interest rate country, and lends in that country will not realize a profit or suffer a loss. It follows from uncovered interest arbitrage that the expected return of a forward contract equals 0 percent.