Question

Covered interest rate arbitrage

As a trader for the London-based money market Commonwealth Fund, you see the following quotes:

A. From Barclays Bank, one-year sterling deposits/loans at 6.0 percent to 6.125 percent.

B. From Bangkok Bank, one-year Thaibaht (THB) deposits/loans at 12.50 percent to 12.75 percent. Spot exchange rate is THB 45 = £1, and one-year forward Thai baht is at 6.00 percent discount vis-à-vis the pound sterling.

Do you see profitable opportunities for interest rate arbitrage? What are the risks, if any, involved in these transactions?

Answer 1

The interest rate to deposit money in UK is 6 percent while in order to deposit money in Thailand is 12.5%. The interest rate differential is 6.50% which is more than 6.00 discount of THB/£. Therefore there is surely an arbitrage opportunity.

The risks are that the future spot may not move as per interest rate parity and there may be a loss by investing in a particular position. This may result from any external reasons such as trade deficit, economic crisis etc