Uncovered Interest 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. 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. 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. If the interest rate differential obtained by investing in a foreign currency is 3%, and the foreign currency appreciates against the domestic currency by 2% during the holding period, the total return from this arbitrage activity is 5%. With uncovered interest arbitrage, there is a foreign exchange risk implicit in this transaction since the investor or speculator will need to convert the foreign currency deposit proceeds back into the domestic currency sometime in the future.
What Is Uncovered Interest 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. With uncovered interest arbitrage, there is a foreign exchange risk implicit in this transaction since the investor or speculator will need to convert the foreign currency deposit proceeds back into the domestic currency sometime in the future.
The term "uncovered" in this arbitrage refers to the fact that this foreign exchange risk is not covered through a forward or futures contract.
How Uncovered Interest Arbitrage Works
Uncovered interest arbitrage involves an unhedged exchange of currencies in an effort to earn higher returns due to an interest rate differential between the two currencies. Total returns from uncovered interest arbitrage depend considerably on currency fluctuations since adverse currency movements can wipe out all the gains and in fact even lead to negative returns. If the interest rate differential obtained by investing in a foreign currency is 3%, and the foreign currency appreciates against the domestic currency by 2% during the holding period, the total return from this arbitrage activity is 5%. On the other hand, if the foreign currency depreciates by 4% during the holding period, the total return is -1%.
Related terms:
Arbitrage
Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from a difference in its price. read more
Covered Interest Arbitrage
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. read more
Covered Interest Rate Parity
Covered interest rate parity refers to a theoretical condition in which the relationship between interest rates and the spot and forward currency values of two countries are in equilibrium. read more
Foreign Currency Fixed Deposit (FCFD)
A foreign currency fixed deposit (FCFD) is a fixed investment instrument in which a sum of money with a fixed term and interest rate is deposited in a bank. read more
Forex Arbitrage
Forex arbitrage is the simultaneous purchase and sale of currency in two different markets to exploit short-term pricing inefficiency. read more
Futures Contract
A futures contract is a standardized agreement to buy or sell the underlying commodity or other asset at a specific price at a future date. read more
Holding Period
A holding period is the amount of time an investment is held by an investor or the period between the purchase and sale of a security. read more
Interest Rate Parity (IRP)
Interest rate parity (IRP) is the fundamental equation that governs the relationship between interest rates and foreign exchange rates. read more
Negative Return
A negative return is characterized by a company's experience of financial loss or an investor's loss on the value of their securities. read more
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. read more