Interest arbitrage and efficiency of foreign exchange market

Interest Arbitrage It refers to the international flow of short term liquid capital to earn higher returns abroad. There are two types of interest arbitrage Covered interest arbitrage Uncovered interest arbitrage

Uncovered interest Arbitrage Since the transfer of funds abroad to take advantage of higher interest rates in foreign monetary centers involves the conversion of the domestic to the foreign currency to make the investment and the subsequent reconversion of the funds plus interest earned form the foreign currency to the domestic currency at the time of maturity ,a foreign currency risk is involved due to the depreciation of the foreign currency during the period for the investment.

If such a foreign exchange risk is covered, we have covered interest arbitrage otherwise ,we have uncovered interest arbitrage. Suppose that the interest rate on a three month treasury bills is 6% in New York and 8% in Frankfurt. It may then pay for a US investor to exchange dollars for Euros at the current spot rate and purchase EU Treasury bills to earn the extra 2% interest.

When EU treasury bill maturs,the US Investor may want to exchange the Euros invested plus the interest earned back into dollars.However,by that time the Euro may have depreciated so that the investor would get back fewer dollars per Euro than he paid. If the Euro depreciates by 1%,the US Investor nets only about 1% form this foreign investment.

If the Euro depreciates by 2%AT An annual basis during the three months. the US investor gains nothing, and if the Euro depreciates by more then 2%,the US Investor loses. Ofcourse,if the Euro appreciates, the US Investor gains both form the extra interest earned and from the appreciation of the Euro.

Covered Interest Arbitrage Investors of short term funds abroad generally want to avoid the foreign exchange risk, therefore interest arbitrage is usually covered. To do this the investor exchanges the domestic for the foreign currency at the current spot rate in order to purchase the foreign treasury bills and at the same time the investor sells forward the amount of the foreign currency he is investing plus the interest he will earn so as to coincide with the maturity of the foreign investment.

Thus,coverd interest arbitrage refers to the spot purchase of the foreign currency to make the investment and the offsetting simultaneous forward sale(swap) of the foreign currency to cover the foreign exchange risk.

When the treasury bill mature, the investor can then get the domestic currency equivalent of the foreign investment plus the interest earned without a foreign exchange risk. Since the currency with the higher interest rate is usually at a forward discount, the net return on the investment is roughly equal to the interest differential in favour of the foreign monetary center minus the forward discount on the foreign currency. This reduction in earning can be viewed as the cost of insurance against the foreign exchange risk

Suppose the interest rate on three month treasury bill is 6% in New York and 8% in Frankfurt and assume that Euro is at a forward discount of 1% per year. To engage in a covered interest arbitrage, the US investor exchanges dollars for Euro at the current exchange rate to purchase the EU treasury bill and the same time sells forward a quantity of Euros equal to the amount invested plus the interest he will earn at the prevailing interest rate.

Since the Euro is at a forward discount of 1% Per year the US investor loses 1% on an annual basis on the foreign exchange transaction to cover the foreign exchange risk. The net gain is the extra 2% interest earned minus the 1% lost on the foreign exchange transaction or 1% on an annual basis.

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