TREASURY CLASSROOM VOLUME 126

COVERED INTEREST RATE ARBITRAGE

Covered Interest rate Arbitrage is possible when the Foreward rate as per the interest rate parity is not equal to the actual forward rate, Like for example if the interest rate between the two countries is not reflected in the forward premium then there is an interest rate arbitrage.

Suppose take an example from the USA and India's Point of view. Suppose the interest rate for six months for USD is around 4% and India is 10% then in that case interest rate difference should be reflected in the forward premium also. Suppose the Spot rate for USD/INR is Rs 62 and forward for six months is around Rs 62.50 Now from the below calculation, we will see whether the premium is as per the IRP exists or not or if there can be some kind of arbitrage is there.

F denotes the forward rate. S denotes the Spot rate. The R(A) denotes the interest rate in the domestic currency and R(B) denotes the interest rate in the foreign currency.

To have interest rate parity F/S= (1+R(A))/(1+R(B))

62.50/60=1.10/1.04

1.04167=1.0576 Which if converted in percentage comes out to be 4.67%=5.76%

Now if you see from the equation the Premium in Dollars as per the Interest rate parity is 5.76% but the actual premium is 4.67%. So there exists an arbitrage opportunity So like one can borrow in dollars and invest in India. Now in this actually the dollar is at less premium than it should be so one should always borrow the US dollars in that case Now if suppose the dollar is at more premium than it should be so one should always invest in the dollar.

So like in the above example one should borrow in US dollars and Invest in INR. As the dollar is at less premium than it should be. So an arbitrageur will do arbitrage in this

Arbitrage Process Let's suppose the notional amount is $100000

Step1. Borrow $100000 at an interest rate of @4% for six months from the bank

Step2- Convert the S100000 at a spot rate of Rs 60 which is Rs 6000000

Step3- Invest Rs 6000000 In India @10% for six months

Step4- Enter into forward contract with an Indian bank to buy $ at Rs 62.50 after six months

After six months

Step5- Post Six months the Arbitrageur will get the investment amount of Rs 6000000(1.10)= Rs 6600000

Step6- Now in this the arbitrageur had also bought the forward contract at Rs 62.50. The dollars which arbitrageur will get Rs 6600000/62.50= $105600

Step7 Post converting it into dollar the arbitrageur will return the borrowed money to the bank now arbitrageur will return $1000000(1.04)= $104000 and the return which he had got from the investing in India was around $105600 so that gain is $1600

Also sometimes there are situations where this suppose Rs 62.50 can go to 70 or can go to 60 so like depreciating and appreciating. So like in the above case if INR starts appreciating then the profit from the arbitrageur will be eroding like suppose the dollar goes to Rs 70 after six months that is on the date of maturity then in that case $100000/70 = $94286 so in that case, the returns would be negative. So arbitrageurs also need to consider the exchange rate scenario while doing hedging

Now the example is only taken for the purpose of understanding the concept of arbitrage.