COVERED INTEREST ARBITRAGE: A STRATEGY TO EARN RISKLESS PROFIT
Sudindra V R
While the spot and forward exchange rates are not at equilibrium and interest rate parity does not persistently hold, there is a prospect to earn riskless profit from covered interest rate arbitrage. Usually interest arbitrage covers short term funds of investors abroad, who want to avoid the foreign exchange risk. It provides a link between foreign exchange markets and money markets in different currencies.
2. MECHANISM OF COVERED INTERST RATE ARBITRAGE
To create riskless profit from interest rate differentials in two countries with forward market, various steps can be followed such as:
Ø Recognize the spot exchange rate and forward exchange rate between two countries and the interest rate of two countries.
Ø Find the interest rate differential between two countries and forward rate differentials between two counties (while forward rate > spot rate, forward premium exists and while forward rate < spot rate forward discount exists).
Ø Equate the interest rate differential (IRD) with forward differentials (FRD), (Assessment rule: IRD > FRD, capitalize in the country where interest rate is higher and if IRD < FRD, capitalize in the country where interest rate is lower).
Ø Arbitrage process:
Ø Borrow money from one country at the prevailing interest rate and convert into another country currency at the prevailing spot exchange rate.
Ø Invest the proceeds of money to obtain the assets, at the end of the period the investment will be giving the interest on purchased assets.
Ø Convert the principal and interest amount in forward rate.
Ø Repay the borrowed amount along with the interest at the end of the period.
Ø Compare the arbitrage proceed with the repayment of borrowed money along with the interest.
Ø The differences between the arbitrage proceeds to repayment of borrowed money gives gain/loss from the arbitrage process.
The mechanism of covered interest rate arbitrage is based on certain assumptions, which includes:
Ø Various assets which will be having different characteristics.
Ø The frequency of time series data varies.
Ø Where there is no transaction cost and tax associated with arbitrage strategy.
Ø The investors borrow and invest money at the prevailing interest rate of RBI and Federal Reserve of USA.
Ø Mechanism is based on assumption of ceteris paribus.
4. EXAMPLE OF COVERED
INTERST RATE ARBITRAGE
INTERST RATE ARBITRAGE
If the sport exchange rate between USD/INR is INR. 66.7905/$,
3 months forward rate available at INR 67.6450/$.
Interest rate in India 6.75% and interest rate in USA is 0.25% (annualized)
How can the investors do the arbitrage?
Ø Interest rate differentials between India and US is (6.75-0.25) = 6.5%
Ø Forward rate differentials between spot and forward market is ((67.6450-66.7905)/66.7905 *100*12/3) = 5.11%
Ø IRD 6.5% > FRD 5.11%, hence arbitrage opportunity exist in the India where interest rate is higher.
Ø Arbitrager can borrow amount in US dollar and invest in India.
Ø Assume arbitragers borrow money of $ 1000 at the prevailing interest rate of 0.25% for 3 months.
Ø Convert $1000 into Indian rupee at the prevailing spot price 66.7905 = INR. 66,790.50
Ø Invest the amount of INR. 66,790.50 in India at the interest rate of 6.75%, at the end of the period the amount becomes (66,790.50+ 66,790.50*6.75%*3/12) = INR. 67,917.59
Ø Convert the above amount in dollar at the forward rate INR. 67,917.59/67.6450 is $ 1004.03
Ø Repay the borrowed amount with interest ( 1000+1000*.25%*3/12) = $ 1000.625
Ø The differences between the arbitrage amount and repayment amount is the gain from arbitrage. (1004.03-1000.625) = $3.4047
Investors can make riskless profit of $ 3.4047 by borrowing money from United States and invest in Indian market, as the interest rate differential is higher than forward differentials. If the interest rate differentials is less than forward differentials, investors can invest in United States by borrowing money from India to gain riskless profit.
Madhu Vij (2011), International financial Management: 3rd Edition, Excel Books, ISBN 978-81-7446-821-5