IILM GURGAON FDFE

COVERED INTEREST ARBITRAGES ---PROF DEEPAK TANDON

CIA is the movement of short term funds between countries to take advantage of
interest differentials with the exchange risk covered by the forward contracts .
When investors purchase the currency of a foreign country to take advantage of
the higher interest rates abroad , they must also consider any losses or gains .
Such gains or losses might occur due to fluctuations in the value of the foreign
currency prior to the maturity of their investment . Generally , the investors cover
against such partial losses by contracting for the future sale or purchase of a
foreign currency in the forward market . Their actions , aimed at profits from the
interest differentials between countries , lead , to an equilibrium , to a condition of
so called interest parity

IRP theory = Any exchange gains / losses incurred by simultaneous purchase / sale
in spot and forward markets are offset by interest rate differential on similar
assets . Under these conditions , there is no incentive for capital to move in either
direction b’cos the effective returns on foreign and domestic assets have been
equalized We ignore the Transaction costs for simplicity

Forward rate reflect the differential over spot rates ,=Difference of Intt rates in
Home & Foreign Country

Borrow at one - converting in another currency = proceeds deposited in 2nd

currency for certain period over during which forward rate differential is not
equivalent to interest rate differential .Deal is closed after arbitrage period, by
reconverting the foreign currency proceeds and earning the difference as profit

Net gain = Interest rate differential – discount / premium on sale of foreign currency
in the forward market . (IRDiffential>Forward Discount }

LHS =(1+rh)

RHS =F/S *(1+rf) LHS is not = RHS ---- Arbitrage exists

• If LHS <RHS --One would borrow home currency , convert receipts to

foreign currency at spot rate , invest in for. Currency denominated securities
9as Foreign Securities carry higher Interest ) . At the same time he will cover
his principal and interest from this investment at the forward rate . At
maturity , he would convert the proceeds of the foreign investment at a
prefixed forward rate and payoff the domestic liability . The difference
between the receipts and payments serve as profit to the customer
• If LHS > RHS ,one would borrow , foreign currency , convert receipts to
domestic currency at a prevailing rate ( Spot ), invest in domestic currency

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 denominated securities ( as domestic securities carry higher interest ) . At the
same time he would cover his principal and interest from this investment at
the forward rate . At maturity , he would convert the proceeds of the
domestic investment at the prefixed domestic forward rate and payoff the
foreign liability . The difference between receipts and payments serve as
profit to customer .

EXAMPLE

Assume that currently , the spot rate is $1.50/Pd Stg and 3 MF is $1.52/Pd Stg . The
3 month Intt Rate is 8.00%p.a in US and 5.8% p.a in UK .Assumethat ewe
canborrow as much as $ 15,00,000 or Pd Stg 10,00,000. Rh=2.0% anfrf=1.45%

IRP

(1+rh)=F/sX(1+rf)

1.02($return ) is not equal to RHS (1.0145) ( 1.52/1.50) = 1.0280 PD Return

Since RHS >LHS We invest in Pound Stg

Arbitrage Process

STEP 1 : Borrow $15,00,000, Repayment will be 15,30,000 @2%

STEP 2 : Buy Pd Stg 10,00,000spot using $ 15,00,000

STEP 3 : Invest Pd Stg 10,00,000at pd interest rate maturity value Pd Stg

10,14,500 {1.45%}

STEP 4 : Sell Pd Stg 10,14,500 Forward for $ 15,42,040 {1PD Stg=$1.52}

Arbitrage profit will be

$ 15,42,040 -15,30,000=$ 12,040

Let us now examine that the Money Market and Forex Markets change post
arbitrage . Following arbitrage , Dollar rate will rise, ( as more $ are borrowed ) and
the Pound sterling rate will fall ( as there will be more inflows ), the spot rate will
rise ( as more pounds are bought in Spot market ) the forward exchange rate will
fall , because of more pounds being sold in the forward market . These adjustments
will continue until IRP is established

ATTEMPT QUESTION

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The annual interest rate in US is 5% and 8% in UK , The spot rate is Pd /$ =1.50 and
Forward exchange rate , with One year maturity is Pd /$ =1.48 . In view of the fact
that the arbitrager can borrow $ 1000000 at the current spot rate , what would be
the arbitrageur profit / Loss ?

HINT LHS not equal to RHS - arbitrage there

1.05 not equal 0.987X(1.08)=1.0656($return)

LHS Lower , borrowing in Dollars –Converted in Pd Stg and invested

Borrowing = 1000000 at rate 5% in 12 M ==1.05x 1000000=1050000

$ 1000000 converted in Pd Stg at spot rate =Pd 666667

Deposit this at 12 m-------Pd Stg 720000 Convert this back in $ = $ 1065600

Our Net Arbitrage profit = $ 1065600 – 1050000=$15600 ANS

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