Covered Interest Arbitrage
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Covered interest arbitrage is an
arbitrage In economics and finance, arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more markets; striking a combination of matching deals to capitalise on the difference, the profit being the difference between the ...
trading strategy whereby an investor capitalizes on the
interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
differential between two countries by using a
forward contract In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of deriva ...
to ''cover'' (eliminate exposure to)
exchange rate risk Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arise ...
. Using forward contracts enables arbitrageurs such as individual investors or
bank A bank is a financial institution that accepts deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital markets. Because ...
s to make use of the
forward premium The forward exchange rate (also referred to as forward rate or forward price) is the exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor. Multinationa ...
(or discount) to earn a riskless profit from discrepancies between two countries' interest rates. The opportunity to earn riskless profits arises from the reality that the
interest rate parity Interest rate parity is a no- arbitrage condition representing an equilibrium state under which investors interest rates available on bank deposits in two countries. The fact that this condition does not always hold allows for potential opportun ...
condition does not constantly hold. When spot and forward exchange rate markets are not in a state of equilibrium, investors will no longer be indifferent among the available interest rates in two countries and will invest in whichever
currency A currency, "in circulation", from la, currens, -entis, literally meaning "running" or "traversing" is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general def ...
offers a higher
rate of return In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows (or securities, or other investments) which the investor receives from that investment, such as interest payments, coupons, ca ...
. Economists have discovered various factors which affect the occurrence of deviations from covered interest rate parity and the fleeting nature of covered interest arbitrage opportunities, such as differing characteristics of
asset In financial accountancy, financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value ...
s, varying frequencies of
time series In mathematics, a time series is a series of data points indexed (or listed or graphed) in time order. Most commonly, a time series is a sequence taken at successive equally spaced points in time. Thus it is a sequence of discrete-time data. Exa ...
data, and the
transaction cost In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike produ ...
s associated with arbitrage trading strategies.


Mechanics of covered interest arbitrage

An arbitrageur executes a covered interest arbitrage strategy by exchanging domestic currency for foreign currency at the current
spot exchange rate A foreign exchange spot transaction, also known as FX spot, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is d ...
, then investing the foreign currency at the foreign interest rate. Simultaneously, the arbitrageur negotiates a forward contract to sell the amount of the
future value Future value is the value of an asset at a specific date. It measures the nominal future sum of money that a given sum of money is "worth" at a specified time in the future assuming a certain interest rate, or more generally, rate of return; it is ...
of the foreign investment at a delivery date consistent with the foreign investment's maturity date, to receive domestic currency in exchange for the foreign-currency funds. For example, as per the chart at right consider that an investor with $5,000,000 USD is considering whether to invest abroad using a covered interest arbitrage strategy or to invest domestically. The dollar deposit interest rate is 3.4% in the
United States The United States of America (U.S.A. or USA), commonly known as the United States (U.S. or US) or America, is a country primarily located in North America. It consists of 50 states, a federal district, five major unincorporated territorie ...
, while the euro deposit rate is 4.6% in the euro area. The current spot exchange rate is 1.2730 $/€ and the six-month forward exchange rate is 1.3000 $/€. For simplicity, the example ignores compounding interest. Investing $5,000,000 USD domestically at 3.4% for six months ignoring compounding, will result in a future value of $5,085,000 USD. However, exchanging $5,000,000 dollars for euros today, investing those euros at 4.6% for six months ignoring compounding, and exchanging the future value of euros for dollars at the
forward exchange rate The forward exchange rate (also referred to as forward rate or forward price) is the exchange rate at which a bank agrees to exchange one currency for another at a future date when it enters into a forward contract with an investor. Multinationa ...
(on the delivery date negotiated in the forward contract), will result in $5,223,488 USD, implying that investing abroad using covered interest arbitrage is the superior alternative.


Effect of arbitrage

If there were no impediments, such as
transaction cost In economics and related disciplines, a transaction cost is a cost in making any economic trade when participating in a market. Oliver E. Williamson defines transaction costs as the costs of running an economic system of companies, and unlike produ ...
s, to covered interest arbitrage, then any opportunity, however minuscule, to profit from it would immediately be exploited by many financial market participants, and the resulting pressure on domestic and forward interest rates and the forward exchange rate premium would cause one or more of these to change virtually instantaneously to eliminate the opportunity. In fact, the anticipation of such arbitrage leading to such market changes would cause these three variables to align to prevent any arbitrage opportunities from even arising in the first place: incipient arbitrage can have the same effect, but sooner, as actual arbitrage. Thus any evidence of empirical deviations from covered interest parity would have to be explained on the grounds of some friction in the financial markets.


Evidence for covered interest arbitrage opportunities

Economists Robert M. Dunn, Jr. and John H. Mutti note that financial markets may generate data inconsistent with interest rate parity, and that cases in which significant covered interest arbitrage profits appeared feasible were often due to assets not sharing the same perceptions of risk, the potential for
double taxation Double taxation is the levying of tax by two or more jurisdictions on the same income (in the case of income taxes), asset (in the case of capital taxes), or financial transaction (in the case of sales taxes). Double liability may be mitigated i ...
due to differing policies, and investors' concerns over the imposition of
foreign exchange controls Foreign exchange controls are various forms of controls imposed by a government on the purchase/sale of foreign currencies by residents, on the purchase/sale of local currency by nonresidents, or the transfers of any currency across national bor ...
cumbersome to the enforcement of forward contracts. Some covered interest arbitrage opportunities have appeared to exist when exchange rates and interest rates were collected for different periods; for example, the use of daily interest rates and daily closing exchange rates could render the illusion that arbitrage profits exist. Economists have suggested an array of other factors to account for observed deviations from interest rate parity, such as differing tax treatment, differing risks, government foreign exchange controls, supply or demand inelasticity, transaction costs, and time differentials between observing and executing arbitrage opportunities. Economists Jacob Frenkel and Richard M. Levich investigated the performance of covered interest arbitrage strategies during the 1970s'
flexible Flexible may refer to: Science and technology * Power cord, a flexible electrical cable. ** Flexible cable, an Electrical cable as used on electrical appliances * Flexible electronics * Flexible response * Flexible-fuel vehicle * Flexible rake re ...
exchange rate regime An exchange rate regime is a way a monetary authority of a country or currency union manages the currency about other currencies and the foreign exchange market. It is closely related to monetary policy and the two are generally dependent on many o ...
by examining transaction costs and differentials between observing and executing arbitrage opportunities. Using weekly data, they estimated transaction costs and evaluated their role in explaining deviations from interest rate parity and found that most deviations could be explained by transaction costs. However, accommodating transaction costs did not explain observed deviations from covered interest rate parity between treasury bills in the United States and
United Kingdom The United Kingdom of Great Britain and Northern Ireland, commonly known as the United Kingdom (UK) or Britain, is a country in Europe, off the north-western coast of the continental mainland. It comprises England, Scotland, Wales and North ...
. Frenkel and Levich found that executing such transactions resulted in only illusory opportunities for arbitrage profits, and that in each execution the
mean There are several kinds of mean in mathematics, especially in statistics. Each mean serves to summarize a given group of data, often to better understand the overall value (magnitude and sign) of a given data set. For a data set, the ''arithme ...
percentage of profit decreased such that there was no
statistically significant In statistical hypothesis testing, a result has statistical significance when it is very unlikely to have occurred given the null hypothesis (simply by chance alone). More precisely, a study's defined significance level, denoted by \alpha, is the p ...
difference from zero profitability. Frenkel and Levich concluded that unexploited opportunities for profit do not exist in covered interest arbitrage. Using a time series dataset of daily spot and forward USD/ JPY exchange rates and same-maturity short-term interest rates in both the United States and Japan, economists Johnathan A. Batten and Peter G. Szilagyi analyzed the sensitivity of forward market price differentials to short-term interest rate differentials. The researchers found evidence for substantial variation in covered interest rate parity deviations from equilibrium, attributed to transaction costs and
market segmentation In marketing, market segmentation is the process of dividing a broad consumer or business market, normally consisting of existing and potential customers, into sub-groups of consumers (known as ''segments'') based on some type of shared characte ...
. They found that such deviations and arbitrage opportunities diminished significantly nearly to a point of elimination by the year 2000. Batten and Szilagyi point out that the modern reliance on
electronic trading platform In finance, an electronic trading platform also known as an online trading platform, is a computer software program that can be used to place orders for financial products over a network with a financial intermediary. Various financial products c ...
s and real-time equilibrium prices appear to account for the removal of the historical scale and scope of covered interest arbitrage opportunities. Further investigation of the deviations uncovered a long-term dependence, found to be consistent with other evidence of temporal long-term dependencies identified in asset returns from other
financial markets A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Some of the securities include stocks and bonds, raw materials and precious metals, which are known in the financial markets ...
including currencies,
stock In finance, stock (also capital stock) consists of all the shares by which ownership of a corporation or company is divided.Longman Business English Dictionary: "stock - ''especially AmE'' one of the shares into which ownership of a company ...
s, and
commodities In economics, a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them. The price of a comm ...
. Economists Wai-Ming Fong, Giorgio Valente, and Joseph K.W. Fung, examined the relationship of covered interest rate parity arbitrage opportunities with
market liquidity In business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the ...
and
credit risk A credit risk is risk of default on a debt that may arise from a borrower failing to make required payments. In the first resort, the risk is that of the lender and includes lost principal and interest, disruption to cash flows, and increased ...
using a dataset of tick-by-tick spot and forward exchange rate quotes for the
Hong Kong dollar The Hong Kong dollar (, currency symbol, sign: HK$; ISO 4217, code: HKD) is the official currency of the Hong Kong, Hong Kong Special Administrative Region. It is subdivided into 100 cent (currency), cents or 1000 Mill (currency), mils. The H ...
in relation to the
United States dollar The United States dollar ( symbol: $; code: USD; also abbreviated US$ or U.S. Dollar, to distinguish it from other dollar-denominated currencies; referred to as the dollar, U.S. dollar, American dollar, or colloquially buck) is the officia ...
. Their empirical analysis demonstrates that positive deviations from covered interest rate parity indeed compensate for liquidity and credit risk. After accounting for these risk premia, the researchers demonstrated that small residual arbitrage profits accrue only to those arbitrageurs capable of negotiating low transaction costs.


See also

*
Uncovered interest arbitrage Uncovered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries. Unlike covered interest arbitrage, uncovered interest arbitrage involves no hedging of foreign exc ...
*
Foreign exchange derivative A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rates of two (or more) currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange r ...


References

{{Reflist Arbitrage Financial economics Interest rates Foreign exchange market International finance fr:Arbitrage (finance)