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Uncovered Interest Arbitrage

Definition

Uncovered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries. Unlike covered interest arbitrage, uncovered interest arbitrage involves no hedging of foreign exchange risk with the use of forward contracts 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.

What is 'Uncovered Interest Arbitrage'

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. 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 some time 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.

Explaining 'Uncovered Interest Arbitrage'

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%.


Further Reading


Covered interest arbitrage and market turbulence
academic.oup.com [PDF]
… For example, given covered interest parity, then testing uncovered interest parity reduces to … I. THE COVERED INTEREST PARITY THEOREM The covered interest rate parity (CIP) theorem states that … flex- price international capital markets and for financial interest-bearing assets …

Covered interest arbitrage profits: The role of liquidity and credit riskCovered interest arbitrage profits: The role of liquidity and credit risk
www.sciencedirect.com [PDF]
… For example, given covered interest parity, then testing uncovered interest parity reduces to … I. THE COVERED INTEREST PARITY THEOREM The covered interest rate parity (CIP) theorem states that … flex- price international capital markets and for financial interest-bearing assets …

A model of covered interest arbitrage under market segmentationA model of covered interest arbitrage under market segmentation
www.jstor.org [PDF]
… For example, given covered interest parity, then testing uncovered interest parity reduces to … I. THE COVERED INTEREST PARITY THEOREM The covered interest rate parity (CIP) theorem states that … flex- price international capital markets and for financial interest-bearing assets …

Covered interest arbitrage: unexploited profits? CommentCovered interest arbitrage: unexploited profits? Comment
www.journals.uchicago.edu [PDF]
… For example, given covered interest parity, then testing uncovered interest parity reduces to … I. THE COVERED INTEREST PARITY THEOREM The covered interest rate parity (CIP) theorem states that … flex- price international capital markets and for financial interest-bearing assets …

Transactions costs and covered interest arbitrage: theory and evidenceTransactions costs and covered interest arbitrage: theory and evidence
www.journals.uchicago.edu [PDF]
… For example, given covered interest parity, then testing uncovered interest parity reduces to … I. THE COVERED INTEREST PARITY THEOREM The covered interest rate parity (CIP) theorem states that … flex- price international capital markets and for financial interest-bearing assets …

Uncovered interest-rate parity over the past two centuriesUncovered interest-rate parity over the past two centuries
www.sciencedirect.com [PDF]
… For example, given covered interest parity, then testing uncovered interest parity reduces to … I. THE COVERED INTEREST PARITY THEOREM The covered interest rate parity (CIP) theorem states that … flex- price international capital markets and for financial interest-bearing assets …

Transaction costs and interest arbitrage: Tranquil versus turbulent periodsTransaction costs and interest arbitrage: Tranquil versus turbulent periods
www.journals.uchicago.edu [PDF]
… For example, given covered interest parity, then testing uncovered interest parity reduces to … I. THE COVERED INTEREST PARITY THEOREM The covered interest rate parity (CIP) theorem states that … flex- price international capital markets and for financial interest-bearing assets …

Uncovered interest rate parity and the term structureUncovered interest rate parity and the term structure
www.sciencedirect.com [PDF]
… For example, given covered interest parity, then testing uncovered interest parity reduces to … I. THE COVERED INTEREST PARITY THEOREM The covered interest rate parity (CIP) theorem states that … flex- price international capital markets and for financial interest-bearing assets …

Emerging market liberalization and the impact on uncovered interest rate parityEmerging market liberalization and the impact on uncovered interest rate parity
www.sciencedirect.com [PDF]
… For example, given covered interest parity, then testing uncovered interest parity reduces to … I. THE COVERED INTEREST PARITY THEOREM The covered interest rate parity (CIP) theorem states that … flex- price international capital markets and for financial interest-bearing assets …



Q&A About Uncovered Interest Arbitrage


If a foreign exchange rate differential is 3, what is the total return if the foreign currency depreciates by 4 during holding period?

The total return would be -1.

What does "uncovered" mean in this context?

Uncovered refers to the fact that there is no forward or futures contract.

If a foreign exchange rate differential is 3, what is the total return if the foreign currency appreciates by 2 during the holding period?

The total return would be 5.

How do total returns from uncovered interest arbitrage depend on currency fluctuations?

Total returns from uncovered interest arbitrage depend considerably on currency fluctuations since adverse currency movements can wipe out all gains and even lead to negative returns.