Results for Covered interest arbitrage
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Banking Dictionary:

Covered Interest Arbitrage

Currency arbitrage carried out by purchasing financial instruments in different currencies and using a Forward Exchange Contract to lock in a yield. An investor buying a two-year bond dominated in German deutschemarks, yielding 5%, might exchange D-marks for dollars in the forward market to buy a U.S. Dollar denominated security of comparable maturity yielding 9%.

 
 
Wikipedia: Covered interest arbitrage

Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency. The proceeds of the investment are only known exactly if the financial instrument is risk-free and only pays interest once, on the date of the forward sale of foreign currency. Otherwise, some foreign exchange risk remains.

Similar trades using risky foreign currency bonds or even foreign stock may be made, but the hedging trades may actually add risk to the transaction, e.g. if the bond defaults the investor may lose on both the bond and the forward contract.

Example

In this example the investor is based in the United States and assumes the following prices and rates: spot USD/EUR = $1.2000, forward USD/EUR for 1 year delivery = $1.2300, dollar interest rate = 4.0%, euro interest rate = 2.5%.

  • Exchange USD 1,200,000 into EUR 1,000,000
  • Buy EUR 1,000,000 worth of euro-denominated bonds
  • Sell EUR 1,025,000 via a 1 year forward contract, to receive USD 1,260,750, i.e. agree to exchange the euros back into US dollars in 1 year at today's forward price.
  • This set of transactions can be viewed as having an effective dollar interest rate of (1,260,750/1,200,000)-1 = 5.1%
  • Alternatively, if the USD 1,200,000 were borrowed at 4%, USD 1,248,000 would be owed in 1 year, leaving an arbitrage profit of 1,260,750 - 1,248,000 = USD 12,750 in 1 year.

Models

Financial models such as interest rate parity and the cost of carry model assume that no such arbitrage profits could exist in equilibrium, thus the effective dollar interest rate of investing in any currency will equal the effective dollar rate for any other currency, for risk-free instruments.

See also

External links

  • Disk Lectures MBA level audio lecture with slideshow on Foreign Exchange

 
 

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Copyrights:

Banking Dictionary. Dictionary of Banking Terms. Copyright © 2006 by Barron's Educational Series, Inc. All rights reserved.  Read more
Wikipedia. This article is licensed under the GNU Free Documentation License. It uses material from the Wikipedia article "Covered interest arbitrage" Read more

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