What is uncovered interest rate arbitrage?
Uncovered interest arbitrage is a form of arbitrage that involves switching from a domestic currency that carries a lower interest rate to a foreign currency that offers a higher rate of interest on deposits.
What is covered interest arbitrage with example?
As a simple example, assume currency X and currency Y are trading at parity in the spot market (i.e., X = Y), while the one-year interest rate for X is 2% and that for Y is 4%. Covered interest arbitrage in this case would only be possible if the cost of hedging is less than the interest rate differential.
What is the difference between covered and uncovered arbitrage?
Covered interest parity involves using forward contracts to cover the exchange rate. Meanwhile, uncovered interest rate parity involves forecasting rates and not covering exposure to foreign exchange riskāthat is, there are no forward rate contracts, and it uses only the expected spot rate.
How do you carry out covered interest arbitrage?
An arbitrageur executes a covered interest arbitrage strategy by exchanging domestic currency for foreign currency at the current spot exchange rate, then investing the foreign currency at the foreign interest rate.
Is Covered Interest Arbitrage riskless?
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.
What is the uncovered interest parity?
Uncovered interest rate parity (UIP) theory states that the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period. It is one form of interest rate parity (IRP) used alongside covered interest rate parity.
What will happen if IRP does not hold?
If the interest rate parity relationship does not hold true, then you could make a riskless profit. The situation where IRP does not hold would allow for the use of an arbitrage. To do this, you would borrow money, exchange it at the spot rate, invest at the foreign interest rate and lock in the forward contract.
What does it mean if UIP holds?
Uncovered Interest Rate Parity
What Is Uncovered Interest Rate Parity (UIP)? Uncovered interest rate parity (UIP) theory states that the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period.
Why does uncovered interest parity hold?
anywhere around the world should have the same price when currency exchange rates are taken into consideration, regardless of its location in the world. The uncovered interest rate parity ensures that an investor gains no excess return by relative changes or differences in foreign exchange rates.
What is the uncovered interest parity condition?
Uncovered interest rate parity (UIP) theory states that the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period.