Explain how banks and individuals can use “covered interest arbitrage” to protect themselves when they make international financial investments
Covered interest arbitrage is a strategy that banks and individuals can utilize to protect themselves when making international financial investments. It involves taking advantage of interest rate discrepancies between different countries to secure a risk-free profit.
Here is a step-by-step explanation of how banks and individuals can use covered interest arbitrage:
1. Identify the interest rate differential: The first step is to identify the difference in interest rates between two countries. Let's consider an example where the interest rate in the home country is 5%, and the interest rate in a foreign country is 7%.
2. Assess the currency exchange rate: The next step is to assess the current exchange rate between the two currencies involved. For instance, if the exchange rate is 1:1, then 1 unit of the home currency can be exchanged for 1 unit of the foreign currency.
3. Calculate the forward exchange rate: Calculate the forward exchange rate, which represents the expected future exchange rate at a specific date in the future. This rate can be obtained from currency futures or forwards markets. Let's assume that the forward rate is 1:1.05, meaning that in the future, 1 unit of the home currency will be exchanged for 1.05 units of the foreign currency.
4. Determine the covered interest rate: Calculate the covered interest rate by factoring in the interest rate differential and the forward exchange rate. In this example, the covered interest rate would be 5% x (1.05/1) = 5.25%.
5. Execute the strategy: To execute covered interest arbitrage, the following steps can be performed:
a. Borrow funds: Borrow money in the home country at the lower interest rate, for example, at 5%.
b. Convert to foreign currency: Convert the borrowed funds into the foreign currency at the current exchange rate of 1:1.
c. Invest in the foreign country: Invest the foreign currency at the higher interest rate of 7%.
d. Hedge the exchange rate risk: Enter into a forward contract to sell the foreign currency at the forward exchange rate of 1:1.05 on the future date, effectively eliminating exchange rate risk.
e. Repay the loan: At the end of the investment period, convert the foreign currency back to the home currency using the forward exchange rate.
f. Calculate profits: Repay the loan with the lower interest rate using the converted home currency. The difference between the interest earned (7%) and the interest paid (5.25%) represents the profit.
By using covered interest arbitrage, banks and individuals can protect themselves against exchange rate fluctuations while taking advantage of interest rate differentials. However, it is important to note that this strategy requires careful analysis of interest rates, exchange rates, and the associated risks involved.