What is covered interest arbitrage?

Covered interest arbitrage is a way some people make money on the differences between interest rates and exchange rates in different countries. It’s a type of arbitrage – which means taking advantage of differences in prices to make a profit.

Currencies, exchange rates and interest rates

To understand how covered interest arbitrage works, you need to know a bit about currencies first. A currency is the money used in a particular country – like dollars in the United States or euros in many European countries. If you want to buy something in another country, you usually need to exchange your currency for the other country’s currency first.

The price you pay to exchange one currency for another is called the exchange rate. Exchange rates change a little bit every day. Sometimes they can change a lot if something big happens in the news.

Interest rates are also important. An interest rate is how much a bank will pay you to keep your money there, or how much you have to pay the bank to borrow money. Interest rates are different in each country and they can also change over time.

Spot rates and forward rates

There are two main exchange rates to know about for covered interest arbitrage:

1. The spot rate is the exchange rate right now, for exchanging currencies today.
2. The forward rate is the exchange rate for exchanging currencies on some date in the future that you agree to ahead of time.

The difference between the spot rate and the forward rate is called the forward premium or forward discount, depending on which way it goes.

How arbitrage works

Here’s the key thing about covered interest arbitrage – it happens when the forward premium (or discount) between two currencies is different than it “should” be based on the difference in interest rates between the two countries.

When this happens, there’s an opportunity for arbitrage. An arbitrageur can:

1. Exchange one currency for the other at today’s spot rate
2. Put that money in the bank in the other country to earn interest
3. At the same time, sign a contract to exchange the currency back at the forward rate on the day the bank deposit ends

If they set it up right, the arbitrageur will end up with a risk-free profit. They’re “covered” because they’ve locked in the forward contract, so they know exactly how much they’ll get back when they exchange the currencies again in the future.

An example of covered interest arbitrage

It’s easier to understand this with an example. Let’s say the exchange rates and interest rates for U.S. dollars and euros are:

• Spot rate: 1.10 dollars per euro
• 1-year forward rate: 1.15 dollars per euro
• 1-year interest rate in the U.S.: 2%
• 1-year interest rate in Europe: 4%

The difference in interest rates (4% – 2% = 2%) is bigger than the forward premium (1.15 – 1.10 = 0.05, which is about 4.5%). This means an arbitrage opportunity exists.

Here’s how an arbitrageur could profit:

1. Borrow $1,000,000 in the U.S. at 2% interest.
2. Exchange the dollars for euros at the spot rate of 1.10. This gives them €909,090.
3. Invest the €909,090 in Europe at 4%. In a year, this will grow to €945,454.
4. At the same time, sign a forward contract to exchange €945,454 back into dollars in one year at the rate of 1.15. They’ll get back $1,087,272.
5. When the year is up, the investment is worth €945,454. Exchange this back into dollars as agreed in the forward contract. This gives $1,087,272.
6. Repay the original loan of $1,000,000, plus 2% interest which is $20,000. Total owed is $1,020,000.

The result: The arbitrageur has $1,087,272 after repaying the $1,020,000 loan. They’ve made a profit of $67,272, just by exploiting the difference between the forward premium and the interest rate differential.

This might seem like easy money, but there are some important things to understand:

• It only works when the forward premium is different than the interest rate differential. This doesn’t happen all the time.
• When it does happen, lots of arbitrageurs rush to take advantage. As they do this, their actions push the exchange rates and interest rates back into alignment, so the opportunity disappears quite quickly.
• You need a lot of money to do this. Profits are usually small as a percentage, so you need big sums to make it worthwhile.
• There are transaction costs – the banks take a cut when you exchange money. This eats into profits.
• If lots of arbitrageurs are trying to do this at once, sometimes they can have trouble getting all the currency they need at the price they expected.

Despite this, covered interest arbitrage is an important part of what keeps global currency and money markets efficient. The constant hunt for arbitrage opportunities by big banks and hedge funds ensures that exchange rates and interest rates stay logical relative to each other. Their actions keep the markets in equilibrium.

The takeaway

At the end of the day, covered interest arbitrage is a fascinating example of how interconnected the global financial system is. It shows how exchange rates, interest rates, and people looking to profit interact in a constant dance. While it’s not something most individuals will ever take part in directly, it’s happening behind the scenes all the time in the global push and pull of currencies.