Understanding Covered Interest Rate Arbitrage

Covered Interest Rate Arbitrage is a financial strategy employed by investors to profit from differences in interest rates between two currencies while simultaneously hedging against exchange rate risk. It involves borrowing funds in one currency, converting them into another currency at the current spot exchange rate, investing the proceeds in interest-bearing securities denominated in the second currency, and then entering into a forward contract to sell the proceeds back into the original currency at a future date.

The process of Covered Interest Rate Arbitrage can be broken down into several steps:

1. Identify Discrepancies: The investor identifies a situation where the interest rates in two countries are sufficiently different to create an arbitrage opportunity. Typically, the investor will look for a scenario where the interest rate in the country with the lower rate is expected to rise or where the forward exchange rate does not align with interest rate differentials.
2. Borrowing: The investor borrows funds in the currency with the lower interest rate. This borrowing is usually done at a short-term interest rate, such as the interbank rate.
3. Currency Conversion: The borrowed funds are then converted into the currency with the higher interest rate at the current spot exchange rate.
4. Investment: The converted funds are invested in interest-bearing securities denominated in the second currency. These securities could include government bonds, corporate bonds, or other fixed-income instruments.
5. Hedging: To hedge against exchange rate risk, the investor enters into a forward contract to sell the proceeds from the investment back into the original currency at a predetermined future date and exchange rate. This locks in the exchange rate, allowing the investor to eliminate the risk of adverse exchange rate movements.
6. Profit Generation: Over the investment period, the investor earns interest income on the securities held in the second currency. At the maturity of the forward contract, the investor receives the proceeds from the investment and uses them to repay the original borrowing. Any difference between the interest earned and the interest paid, adjusted for exchange rate movements, represents the investor’s profit from the arbitrage strategy.

Covered Interest Rate Arbitrage relies on the principle of interest rate parity, which suggests that the forward exchange rate should reflect the interest rate differentials between two currencies. However, deviations from interest rate parity can occur due to factors such as transaction costs, capital controls, and market inefficiencies, creating opportunities for arbitrageurs to exploit.

Let’s illustrate Covered Interest Rate Arbitrage with an example:

Suppose an investor notices the following scenario:

• Current spot exchange rate: 1 USD = 75 INR
• Interest rate in the United States (USD): 3% per annum
• Interest rate in India (INR): 5% per annum

Step 1: Borrowing
The investor borrows $1,000,000 USD at an annual interest rate of 3%.

Step 2: Currency Conversion
The investor converts the borrowed $1,000,000 USD into Indian Rupees (INR) at the spot exchange rate of 1 USD = 75 INR, resulting in 75,000,000 INR.

Step 3: Investment
The investor invests the 75,000,000 INR in Indian government bonds with a maturity of one year, earning an annual interest rate of 5%.

Step 4: Hedging
To hedge against exchange rate risk, the investor enters into a one-year forward contract to sell 75,000,000 INR and buy $1,000,000 USD at a forward exchange rate of 1 USD = 76 INR. This locks in the exchange rate for the future conversion of INR back to USD.

Step 5: Profit Generation
Over the one-year investment period:

• Interest earned on Indian government bonds: 75,000,000 INR * 5% = 3,750,000 INR
• Interest paid on USD borrowing: $1,000,000 USD * 3% = $30,000 USD

At the maturity of the forward contract, the investor receives 75,000,000 INR from the investment and uses it to fulfill the forward contract, converting it back to $1,000,000 USD at the predetermined rate of 1 USD = 76 INR.

Let’s calculate the total profit:

• Interest earned in INR: 3,750,000 INR
• Interest paid in USD (converted to INR at the forward rate): $30,000 USD * 76 INR/USD = 2,280,000 INR

Net profit = Interest earned – Interest paid = 3,750,000 INR – 2,280,000 INR = 1,470,000 INR

In this example, the investor earns a profit of 1,470,000 INR by exploiting the interest rate differential between the two currencies through Covered Interest Rate Arbitrage.