What would an uncovered interest arbitrage imply?

The term “uncovered” in this arbitrage refers to the fact that this foreign exchange risk is not covered through a forward or futures contract. Uncovered interest arbitrage involves an unhedged exchange of currencies in an effort to earn higher returns due to an interest rate differential between the two currencies.

What is meant by covered interest arbitrage?

Covered interest rate arbitrage is the practice of using favorable interest rate differentials to invest in a higher-yielding currency, and hedging the exchange risk through a forward currency contract.

What is covered interest arbitrage and uncovered interest arbitrage?

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.

What is the difference between covered and uncovered arbitrage?

Covered interest parity involves using forward contracts to cover the exchange rate. Meanwhile, uncovered interest rate parity involves forecasting rates and not covering exposure to foreign exchange risk—that is, there are no forward rate contracts, and it uses only the expected spot rate.

How do you calculate uncovered interest arbitrage?

Formula for Uncovered Interest Rate Parity (UIRP)

1. Et[espot(t + k)] is the expected value of the spot exchange rate.
2. espot(t + k), k periods from now.
3. k is number of periods in the future from time t.
4. espot(t) is the current spot exchange rate.
5. iDomestic is the interest rate in the country/currency under consideration.

What is called covered arbitrage?

Covered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries by using a forward contract to cover (eliminate exposure to) exchange rate risk.

How can you avoid covering interest arbitrage?

To minimize this currency risk in a covered interest arbitrage, an investor executes a usual interest arbitrage, as well as buys a forward contract. The expiry date of the forward contract should be similar to the maturity of the foreign investment.