As you might already know, currency trading is quite different from trading in the stocks of companies. And since forex trading is a vast financial market, the strategies that you can use to profit from the currency movements are also different and more extensive. One such trading strategy that is most often used when trading in currencies is the covered interest arbitrage.

This interest arbitrage strategy not only helps you limit the exchange rate risk between two currencies, but also allows you to gain from the market movements. If the question ‘what is covered interest arbitrage?’ is running on your mind right now, read on to know the answer to it.

What is interest arbitrage?

Before we look at the answer to the question ‘what is covered interest arbitrage?’, let’s quickly take a detour and understand the concept of interest arbitrage.

In the stock market, there’s a price difference for the same asset in the spot (cash) market and the derivatives (futures and options) market, right? Similarly, with respect to the deposit and lending interest rates, different countries offer different rates. For instance, the interest rate of the United States of America is currently at 0.25%, whereas the interest rate of the United Kingdom is currently at 0.1%.

Here is where it gets interesting. An investor can make use of this difference in the interest rates between two countries to enjoy risk-free gains from their investment using a strategy known as interest arbitrage.

Interest arbitrage is technically a trading and investment strategy that involves an investor converting his investment capital to the currency of a country with a higher interest rate and investing the same in that country. The amount of profit that he generates by investing the money in the country with a higher interest rate would be more than what he would earn if he invested it domestically.

What is covered interest arbitrage?

Here’s a key point that you should note with respect to interest arbitrage. Since the exchange rates between two currencies are constantly changing, there’s always an element of exchange rate risk involved with this strategy.

For instance, let’s assume that the exchange rate was low when you converted your investment capital to a foreign currency. After reaping the returns from your investment, you find that the exchange rate has fallen even further. This is what is called an exchange rate risk and it can end up significantly nullifying any positive effects that you might have enjoyed with the interest arbitrage strategy. However, there’s a way to limit this exchange rate risk. Here’s where the covered interest arbitrage comes into the picture.

To put it in simple terms, for a covered interest arbitrage, you execute a traditional interest arbitrage strategy and simultaneously also purchase a forward contract. The forward contract should ideally have an expiry date that matches the maturity date of your foreign investment. This way, you can effectively lock-in the exchange rate price beforehand and thereby nullify the exchange rate risk, which you would have otherwise had to endure.

Let’s take up an example to better understand this concept. Assume that you have around $100,000 with you. The current interest rate in the U.S is around 3%. You decide to invest the money in a country where the interest rates are higher. The interest rates in the EU (European Union) is currently at around 4%. And so, you decide to invest your $100,000 in the EU.

And so, you decide to convert your investment capital from U.S. Dollars to Euros. The prevailing USD EUR exchange rate is 0.85, which means that for every USD, you get around 0.85 Euros. So, after conversion, your investment capital becomes €85,000 (100,000 x 0.85). You then decide to invest €85,000 at an interest rate of 4% in the EU for a period of 1 year.

And since you don’t know what the exchange rate of the USD EUR pair would be a year from now, you decide to nullify this exchange rate risk. And so, you initiate a forward contract with a financial institution  to lock-in your exchange rate. The value of the forward contract would be €88,400 [€85,000 + (€85,000x 4%)], with a maturity date that matches that of your investment. With the forward contract, you lock-in an exchange rate of 1.20 (EUR USD).

At the end of the investment tenure, you receive €88,400, which you then promptly exchange to U.S. Dollars with the exchange rate of 1.20 (EUR USD). This comes up to around $106,080. If you had invested $100,000 in the U.S. markets at an interest rate of 3%, you would have only received ($103,000). By utilizing the covered interest arbitrage, you not only nullified your risk, but you were also able to gain an additional return of around $3,080.

Conclusion

The covered interest arbitrage might sound complicated, but is in fact one of the easiest ways to earn an almost risk-free return on investment. Here’s a word of caution. Due to the differences between interest rates of different countries being slim, the returns you earn through this method might not be very high when compared to other investment options. That said, this investment strategy is hugely popular with institutional investors who are constantly making use of such interest arbitrage strategies to earn returns on their investment.