Covered Interest Arbitrage: Meaning, Procedure and Example

Covered Interest Rate Arbitrage (CIRA) is a simple investment strategy that falls under strategic financial management, you know, because it has strategies and stuff. Also because it involves money, so its, financial and stuff. Let’s just get into it.

But before we get into it, it being Covered Interest Rate Arbitrage, there is a little birdie called Interest Rate Parity (IRP) we have to meet first, because Covered Interest Rate Arbitrage is kind of extension to Interest Rate Parity, sort of like what 2001: A Space Odyssey is to Interstellar, see Interstellar is a better movie but there wouldn’t be an Interstellar if there was no 2001: A Space Odyssey.

What is Interest Rate Parity?

This economic theory basically shows how the relationship between interest rates in different countries and currency exchange rates move. It shows how the difference between interest rates in two countries are offset by differentials in its currency exchange rate.

Think of it as saying there is no benefit in getting a higher risk-free rate in other countries because whatever marginal return would be offset by currency exchange rates, and in the end you end up getting exactly what you would have gotten in your home country. This, of course, is not the case in real life because there exists a little something called arbitrage.

Basically, this means that your forward rate of a currency would always be equal to the spot price accounted for interest rate premium.

In an equation sort of thing, it looks something like this

Forward Rate / Spot Rate = (1 + Interest Rate in Home Country) / (1 + Interest Rate in Foreign Country)

Alright, clearly you might have understood that.

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Don’t worry if you didn’t, it matters only in its existence, but it’ll be much clearer when we discuss IRA.

What is Covered Interest Rate Arbitrage? Meaning

First of all, Covered Interest Rate Arbitrage is a forward derivative based investment strategy. Arbitrage basically means taking advantage of difference in spot rates of the same asset, to make profit. Covered, in this scenario, means it is hedged by a forward contract. Let’s understand what it is by breaking down step by step on how one does it.

Covered Interest Rate Arbitrage Example

First of all, you need two countries, take for instance US and India. The current exchange rate, that means the spot price, is going Rs. 60 per USD. Then, you promptly check on the forwards market, and you find out that the one year forward rate for USD is going at Rs. 65 per USD.

What is also known, is the interest rates in both the countries, which for the sake of simplicity, we’ll assume are common for both borrowing and lending. The interest rate in India is 22% p.a. and interest rate in USA is 10% p.a.

Now some guy on some blog shoved the concept of Interest Rate Parity randomly while you were trying to research something else, which said the forward rate premium in dollars has to equal in both currency and interest at any given time, so you decide to put that theory to test.

You calculate Dollar premium as per forward and spot rates, (Forward Rate / Spot Rate i.e. 65/60), which gives you 8.33% premium on forward in the year. Then you calculate the dollar premium through interest rates (1+0.22/1+0.1) which gives you 10.9% premium.

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Now, according to Interest Rate Parity (IRP), the forward rate should have grown at 10.9% premium, because the interest rates have grown by that amount. But it didn’t. There is a gap of 2.57% where you can make a profit.

See, because USD would not have grown at the rate it should have, you decide to borrow $ 100,000 now, then convert it into rupees, at the current spot rate, giving you Rs. 60,00,000.  Then you deposit that money into the bank. Along with that, because currencies keep fluctuating, you buy a forward contract that guarantees that after an year, you get to exchange your rupees into dollar at the rate of Rs. 65.

After an year, the 60 lakh rupees would have earned 22% interest, making the amount Rs. 73,20,000. On the other hand, your borrowed money has incurred a liability of 10%, making your payment due after one year to be $ 110,000.

You use the contract to convert rupees into dollar at Rs. 65, making your dollar amount to be approximately $112600. The difference i.e. $2600 is your arbitrage profit.

This process is called covered interest arbitrage. We hope you got it right! You covered your interest arbitrage position with a forward contract. Here’s few things you need to take care of.

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Covered Interest Arbitrage: Risks Associated

1. Interest Rate Fluctuations:

The first is the most obvious one. We have assumed that the interest rates remain stable throughout, which in real life is not the case. Interest rates keep fluctuating, also they’re usually not common.

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2. Regulation Risk:

The second one is because the position transcends country borders, there is always regulation risk, in terms of both taxes and investment limits, along with international relations with that country. Remember how Tom Hanks’s character got stock for years on the airport because his home country’s government got overthrown while he was mid-air in the movie The Terminal? That stuff.

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3. Other Procedural Risks:

The third is a batch of risks associated with procedural aspect of it. It is important that there should be difference between dollar premiums, also forward contract made holds till maturity, of course currency fluctuations as well. Also, because the profit margin is so small, a higher amount of money has to be put up to make profits.

Covered Interest Arbitrage: The Bottom Line

Covered Interest Rate Arbitrage can be a great way to make money, but it requires patience and market credibility. You’re not actually using any of your own money, along with a lot of algorithms to adapt in today’s world.

What do you think? Is Covered Interest Arbitrage an ideal strategy to earn profits and limit your exposure to the wide exchange rate risks? Do share your opinions thereon.

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