Uncovered interest arbitrage is an

arbitrage Arbitrage (, ) is the practice of taking advantage of a difference in prices in two or more marketsstriking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which th ...

trading strategy whereby an investor capitalizes on the

interest rate An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, ...

differential between two countries. Unlike covered interest arbitrage, uncovered interest arbitrage involves no hedging of

foreign exchange risk Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arise ...

with the use of

forward contract In finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on in the contract, making it a type of derivative instrument.John C Hu ...

s or any other contract. The strategy involves risk, as an investor exposed to exchange rate fluctuations is speculating that exchange rates will remain favorable enough for arbitrage to be profitable. The opportunity to earn profits arises from the reality that the uncovered interest rate parity condition does not constantly hold—that is, the interest rate on investments in one country's currency does not always equal the interest rate on foreign-currency investments plus the rate of appreciation that is expected for the foreign currency relative to the domestic currency. When a discrepancy between these occurs, investors who are willing to take on risk will not be indifferent between the two possible locations of investment, and will invest in whichever

currency A currency is a standardization of money in any form, in use or circulation as a medium of exchange, for example banknotes and coins. A more general definition is that a currency is a ''system of money'' in common use within a specific envi ...

is expected to offer a higher

rate of return In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows (or securities, or other investments) which the investor receives from that investment over a specified time period, such as i ...

including currency exchange gains or losses (perhaps adjusted for a risk premium).

Mechanics of uncovered interest arbitrage

An arbitrageur executes an uncovered 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, and at the end of the investment term using the spot foreign exchange market to convert back to the original currency. The risk arises from the fact that the future spot exchange rate for the currencies is not known with certainty when the strategy is chosen. For example, consider that an investor with US$5,000,000 is considering whether to invest abroad using an uncovered interest arbitrage strategy or to invest domestically. The dollar deposit interest rate is 3.4% in the

United States The United States of America (USA), also known as the United States (U.S.) or America, is a country primarily located in North America. It is a federal republic of 50 U.S. state, states and a federal capital district, Washington, D.C. The 48 ...

, while the euro deposit rate is 4.6% in the

euro area The euro area, commonly called the eurozone (EZ), is a currency union of 20 member states of the European Union (EU) that have adopted the euro (€) as their primary currency and sole legal tender, and have thus fully implemented EMU pol ...

. The current spot exchange rate is 1.2730 $/€. For simplicity, the example ignores compounding interest. Investing US$5,000,000 domestically at 3.4% for six months ignoring compounding, will result in a future value of US$5,170,000. However, exchanging US$5,000,000 for euros today, investing those euros at 4.6% for six months ignoring compounding, and exchanging the future value of euros for dollars at the future spot exchange rate (which for this example is 1.2820 $/€), will result in US$5,266,976, implying that investing abroad using uncovered interest arbitrage is the superior alternative if the future spot exchange rate turns out to be favorable.

References

{{Reflist Arbitrage Financial economics Foreign exchange market

Mechanics of uncovered interest arbitrage

See also

References