Covered interest arbitrage and uncovered interest arbitrage are basically two forms of arbitrage. Recently, both forms have become quite popular in various sectors of the financial market. A covered interest arbitrage is that form of arbitrage in which an investor purchases a financial instrument in a particular foreign exchange denomination and the foreign exchange risk involved in the transaction is hedged by performing a forward contract sale in the financial instrument sales proceeds in the domestic currency once again.
The investor is able to know the exact proceeds of the transaction only if the investment is risk-free in nature and interest is received by the investor only once. The interest is paid to the investor on that particular day when the forward contract sale in foreign exchange takes place. Alternatively, there is a certain degree of foreign currency risk involved.
Same types of trade that use overseas stocks or foreign exchange bonds that are risky in nature might be performed. Nevertheless, there is an increased chance of risk in this type of hedging transactions, for example, if there is a default on the bond, the investor has the risk of losing both the forward contract, as well as the bond. Various types of financial models that are implemented in case of covered interest arbitrage include the cost of carry model and interest rate parity model.
These models presume that there is no presence of arbitrage profits in case of equilibrium.
As a result, the dollar rate of interest prevailing for the purpose of investment in any foreign exchange will be similar to the prevailing dollar rate of interest for any other type of foreign exchange in case of risk-free investments.
Uncovered interest arbitrage is that type of arbitrage where there is a transfer of funds to overseas locations for taking the benefit of enhanced interest rates in foreign exchange bureaus or foreign exchange agencies. In this type of investments, the domestic currency is changed over to a foreign exchange and again at maturity period, the proceeds from the foreign exchange are reconverted to the base (domestic) currency.
In this approach, there is an involvement of foreign currency risk because of the probable decrease in the value of the foreign exchange in the duration of investment period.
Last Updated on : 1st July 2013