Interest rates have an effect on the bond market, and to a lesser extent, the stock market. Foreign interest rates can have a positive or negative impact on foreign bonds or other assets as well. Not commonly known is that it is possible to profit from the difference in interest rates between countries. Interest rates vary between countries based on their current economic cycle, which creates an opportunity for investors.
By purchasing foreign currency with a domestic currency, investors can profit from the difference between the interest rates of two countries. Arbitrage in investments refers to an investing strategy that capitalizes on market inefficiencies to trade nearly risk-free.
This arbitrage strategy has become commonplace, with the near-instantaneous transaction abilities of the technological trader. The most common type of interest rate arbitrage is called covered interest rate arbitrage, which occurs when the exchange rate risk is hedged with a forward contract.
Since a sharp movement in the foreign exchange forex market could erase any gains made through the difference in exchange rates, investors agree to a set currency exchange rate in the future in order to erase that risk.
For example, suppose that the U. Using forward contracts, investors can also hedge the exchange rate risk by locking in a future exchange rate. The carry trade is a form of interest rate arbitrage that involves borrowing capital from a country with low-interest rates and lending it in a country with high-interest rates.
These trades can be either covered or uncovered in nature and have been blamed for significant currency movements in one direction or the other as a result, particularly in countries like Japan.
In the past, the Japanese yen has been extensively used for these purposes due to the country's low-interest rates. Traders would borrow yen and invest in higher-yielding assets, like the U. The key to a carry trade is finding an opportunity where interest rate volatility was greater than the exchange rate's volatility in order to reduce the risk of loss and create the "carry.
But, that doesn't mean that there aren't any opportunities. Despite the impeccable logic, interest rate arbitrage isn't without risk.
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.
To create riskless profit from interest rate differentials in two countries with forward market, various steps can be followed such as:. The mechanism of covered interest rate arbitrage is based on certain assumptions, which includes:. Your Money. Personal Finance. Your Practice. Popular Courses. Key Takeaways The covered interest rate parity condition says that the relationship between interest rates and spot and forward currency values of two countries are in equilibrium.
It assumes no opportunity for arbitrage using forward contracts. Covered and uncovered interest rate parity are the same when forward and expected spot rates are the same. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.
We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear.
Investopedia does not include all offers available in the marketplace. Understanding Uncovered Interest Rate Parity — UIP Uncovered interest rate parity UIP states that the difference in two countries' interest rates is equal to the expected changes between the two countries' currency exchange rates. Covered Interest Arbitrage Definition Covered interest arbitrage is a strategy where an investor uses a forward contract to hedge against exchange rate risk.
Returns are typically small but it can prove effective. Uncovered Interest Arbitrage Uncovered interest arbitrage involves switching from a lower interest rate currency to a higher interest rate currency in order to increase returns. Forward Discount Definition A forward discount occurs when the expected future price of a currency is below the spot price, which indicates a future decline in the currency price.
Forward Premium A forward premium occurs when the expected future price of a currency is above spot price which indicates a future increase in the currency price. Partner Links.
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