Question

1： What is the international financial investment with Cover? How does covered interest arbitrage work? Please discuss with an example

2： What is the international financial investment without Cover? How does uncovered interest arbitrage work? Please discuss with an example.

Answer 1

Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract. The logic of the term covered interest arbitrage becomes clear when it is broken into two parts: “interest arbitrage” refers to the process of capitalizing on the difference between interest rates between two countries; “covered” refers to hedging your position against exchange rate risk.

Even if covered interest arbitrage appears feasible after accounting for transaction costs, investing funds overseas is subject to political risk. Though the forward contract locks in the rate at which the foreign funds should be reconverted, there is no guarantee that the foreign government will allow the funds to be reconverted. A crisis in the foreign country could cause its government to restrict any exchange of the local currency for other currencies. In this case, the investor would be unable to use these funds until the foreign government eliminated the restriction.

Investors and firms that set up deposits in other countries must be aware of the existing tax laws. Covered interest arbitrage might be feasible when considering before-tax returns but not necessarily when considering after-tax returns. Such a scenario would be due to differential tax rates.

For example interest rates in the United States and Switzerland need not be the same , but, if a wealthy Swiss individual thought about converting CHF today into USD (in order to capture the higher interest of 5% in the United States, relative to the Swiss rate of interest of 3%) and also attempted to convert those Dollars back into Swiss Francs using the forward market (because, after all, this person is Swiss), they would end up with the same amount of CHF as if they had simply invested it directly in their Swiss bank at a rate of interest of 3%.

Uncovered interest arbitrage is to borrow in countries and currencies w/ relatively low interest rates and convert the proceeds into currencies that offer much higher interest rates. This transaction is “uncovered” b/c the investor does not sell the higher yielding currency proceeds forward.

Suppose the risk free rate for currency B is higher than that for currency A, and that the difference in interest rates is greater than the expected depreciation of currency B against currency A (both over the same period).

1. Sell currency A and buy B.
2. Invest the amount of B bought is risk free securities.
3. When the securities mature convert the holding of B back to A.

If currency A is borrowed, then this is called a carry trade (because the interest on the borrowed amount is a carrying cost).