COVERED INTEREST ARBITRAGE

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MEANING OF COVERED INTEREST ARBITRAGE

Under Covered Interest Arbitrage (CIA) arbitrageur takes the advantage of interest rate differential between two countries by hedging himself under forward contract to earn riskless profit.

The term ‘Covered’ means hedging through forward contract in forex market against fluctuation in exchange rate and the term ‘Interest Arbitrage’ means taking advantage of interest differential between two countries.

Covered Interest Arbitrage is possible only when Interest Rate Parity (IRP) is not valid. That means interest differential is not equal to percentage of spread between two currencies.

Arbitrage means taking advantage of mispricing of similar asset without taking risk.

IDENTIFICATION OF CIA POSSIBILITY

Now let’s understand in simple words. In Covered Interest Arbitrage arbitrage there would be two scenario and our action would be based on under or overpricing of base currency.

For determining whether the currency is overpriced or under-priced we will calculate theoretical Forward Rate based on IRP. Then we will compare theoretical FR with quoted FR. If quoted FR is more than theoretical FR that means base currency is overpriced or if quoted FR is less than theoretical FR that means base currency is under-priced.

Scenario I – Base Currency Overpriced in Forex Market
  • To take benefit of overpricing, an arbitrager will sell (short position) base currency in Forex Market
  • In this case to cover above position an arbitrager has to deposit (long position) base currency in Money Market.
  • To deposit the base currency, he has to borrow in price currency in Money Market and convert the borrowed price currency in base currency for deposit.
Scenario II – Base Currency Under-priced in Forex Market
  • To take benefit of under-pricing, an arbitrager will buy (long position) base currency in Forex Market
  • In this case to cover above position an arbitrager has to borrow (long position) base currency in Money Market.

After borrowing in base currency, he will deposit in price currency in Money Market by converting the borrowed base currency in price currency.

EXAMPLE- (BASED ON SCENARIO I)

Spot- 1 DM = Canadian $ .665

3 Month- 1 DM = Canadian $ .670

Interest Rate DM = 7% Canada = 9%

What operations would be carried out to take the possible arbitrage gain? If yes then how an arbitrager can take advantage of the situation if he is willing to borrow Canadian $ 6650.

Ans: –

Theoretical FR = .665 * (1 + (.09 * 3/12) /   (1 + (.07 * 3/12)

1 DM = Canadian $ .668

Since quoted FR is not equal to theoretical FR that means Covered Interest Arbitrage is possible.

Here quoted FR > Theoretical FR, that means base currency which DM, is Overpriced in Forex Market.

As the base currency is overpriced, let’s apply the action of Scenario I-

T = 0

Step I- Enter into forward contract to sell DM-   1DM = CAD $.670

Step II – Borrow CAD $ 6650 for 3 months @ 9%

Step III – Convert CAD $ into DM at spot rate = 6650/.665 = 10,000 DM

Step IV – Deposit DM 10,000 for 3 months @ 7%

T = 3 Months

Step I – DM Deposit proceed received = 10,000 * (1 + (.07 * 3/12))

                                                          = DM 10,175

Step II – Sell DM 10,175 at agreed FR to get Canadian $ = 10,175 * .670

                                                                                       = 6817.25

Step III – Repay borrowed Canadian $ = 6,650 * (1 + (.09 * 3/12))

                                                          = 6,800 approx.

Profit = 6,817.25 – 6800 = Canadian $ 17.25

EXAMPLE- (BASED ON SCENARIO II)

Spot Rate 1US$ = Rs. 48.0123

180 days FR for 1 US$ = Rs. 48.8190

Annualised interest rate for 6 Months – Rupee = 12%

Annualised interest rate for 6 Months – US$ = 8%

Is there any arbitrage possibility? If yes how an arbitrageur can take advantage of the situation, if he is willing to borrow Rs. 40,00,000 or US$ 83,312.

Ans: –

Theoretical FR = 48.0123 * (1 + (.12 * 180/360) / (1 + (.08 * 180/360)

1 US$ = Rs.48.9356

Since quoted FR is not equal to theoretical FR that means Covered Interest Arbitrage is possible.

Here quoted FR < Theoretical FR, that means base currency which is US$, is Under-priced in Forex Market.

As the base currency is under-priced, let’s apply the action of Scenario II-

T = 0

Step I- Enter into forward contract to buy US$-   1US$ = Rs. 48.8190

Step II – Borrow US $ 83,312 for 6 months @ 8%

Step III – Convert US $ into Rupee at spot rate = 83,312 * 48.0123 = Rs. 40,00,000

Step IV – Deposit Rs. 40,00,000 for 6 months @ 12%

T = 6 Months

Step I – Rupee Deposit proceed received = 40,00,000 * (1 + (.12 * 6/12))

                                                          = Rs. 42,40,000

Step II – Buy US$ at agreed FR through deposit proceed = 42,40,000/48.8190

                                                                                     =US$ 86,851 approx.

Step III – Repay borrowed US $ = 83,312 * (1 + (.08 * 6/12))

                                                          = 86,644 approx.

Profit = 86,851 – 86,644 = US $ 207

DECISION PROCESS, TO SELL OR BUY BASE CURRENCY

Let’s understand with normal life examples. Suppose you went to the market to buy any product. In your mind and according to current market scenario the price of that product should be Rs. 10,000 but when you asked for price in the market you have got the price quote Rs. 9,900. Then in this case you will definitely buy that product.

Likewise, here in forex market we calculate price for a currency by applying IRP to know the reasonable price for a currency. Then we compare that price with market quoted price. If the price of that currency is lower than our expected price then we will buy that currency to take the benefit of that cheap rate but if the price of that currency is higher than our expected price then we will sell that currency to take the benefit of higher quote.


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