Covered Interest Arbitrage

Example (The Basics): When deciding which country to invest (Home vs Abroad)
Note: Nominal interest rate refers to the interest rate before taking inflation into account.
Nominal can also refer to the advertised or stated interest rate on a loan, without taking into
account any fees or compounding of interest.
DATA
Definition of Variables Data
S= Spot Rate S= 2E/$
F= Forward Rate F= 1.8E/$
R(U.S.) = Nominal Interest Rate in the U.S. R(U.S.) = 10% p.a.
R(E)= Nominal Interest Rate in Euro Zone R(E)= 5% p.a
M= Amount of Money

Amount of money you want to invest (M): $100

Assuming U.S. is home country Assuming Euro Zone as Foreign Country
Invest at home to get: 1. Convert $100 into Euros using the spot rate:
100 (1.10)
= $110 S= 2E/$
Multiply: Denominator currency to Numerator
currency
100 x 2 = 200 Euros

2. Invest 200 Euros in foreign country to get:

200 (1.05) = 210 Euros

3. Convert Euros back to home currency using

the forward rate:

F= 1.8E/$
Divide: Numerator currency to denominator
currency
210/1.8 = $116.67

Covered Interest Arbitrage (CIA) $116.67 - $110 = $6.67

Profit
Conclusion: Invest Abroad

1
Covered Interest Arbitrage
Example: Deciding which country to start from
Note: Nominal interest rate refers to the interest rate before taking inflation into account.
Nominal can also refer to the advertised or stated interest rate on a loan, without taking into
account any fees or compounding of interest.
DATA:
Definition of Variables Data
S= Spot Rate S= 2E/$
F= Forward Rate F= 1.8E/$
R(U.S.) = Nominal Interest Rate in the U.S. R(U.S.) = 10% p.a.
R(E)= Nominal Interest Rate in Euro Zone R(E)= 5% p.a
M= Amount of Money

1) Assuming the U.S. as home, find the forward premium/discount on the foreign
currency as follows:

FC =¿¿
f ¿ ] × 100

2−1.8 360
= [ 1.8 × 360 ] × 100

= 11.11%

2) Find the absolute interest rate differential (i ¿¿ d) ¿ between the countries:

i d = R(U.S.) – R(E)

i d =¿ 10 %−5 %

i d = 5%

FC
3) If i d ˂ f ¿ ¿, borrow in the higher interest rate country and invest in the lower interest
rate country.

FC
4) If i d ˃ f ¿ ¿, borrow in the lower interest rate country and invest in the higher
interest rate country.
2
 FC
5) In this example, i d ˂ f ¿ ¿. therefore, we should borrow in U.S. (higher interest rate
country) and invest in the Euro Zone (lower interest rate country).

6) Borrow $100 and convert them to Euro at Spot rate:

S= 2E/$
Denominator currency to Numerator currency: Multiply
So, 100 x 2 = 200 Euros

Invest @ R(E) = 5% and end up with: 200 (1.05) = 210 Euros

Convert Euros back to forward rate:

1.8E/$
Numerator currency to Denominator currency: Divide
So, 210/1.8 = $116.67

Repay the loan= 100 (1.10) = $110

CIA Profit= 116.67 – 110 = $16.67

3
End of Chapter Problem 7
The treasurer of a major U.S. fi rm has $30 million to invest for three months. The interest rate in
the United States is .24 percent per month. The interest rate in Great Britain is .29 percent per
month. The spot exchange rate is £.631, and the three-month forward rate is £.633. Ignoring
transaction costs, in which country would the treasurer want to invest the company’s funds?
Why?
If we invest in the U.S. for the next three If we invest in Great Britain for the next
months, we will have: three months, we must exchange the pounds
for dollars:
$30,000,000 (1.0024)3
= $30,216,518.81 S= £.631/$
Multiply:
$30,000,000 (£.631)
= £18,930,000

Invest £18,930,000 @ 0.29% per month

£18,930,000(1.0029)3
= £19,095,169.07

Convert £19,095,169.07 to USD

F= £.633/$
Divide:
19,095,169.07/.633
= $30,166,143.86

Conclusion: The company should invest in

the U.S.

4
End of Chapter Problem 10
Suppose the spot and six-month forward rates on the Norwegian krone are Kr 5.78 and Kr 5.86,
respectively. The annual risk-free rate in the United States is 3.8 percent, and the annual risk-free
rate in Norway is 5.7 percent.
a. Is there an arbitrage opportunity here? If so, how would you exploit it?
b. What must the six-month forward rate be to prevent arbitrage?

DATA:
Data
S= Kr5.78/$
F= Kr5.86/$
R(U.S.) = 3.8% p.a
R(Kr)= 5.7% p.a.

PART A
1) Forward premium/discount on the foreign currency as follows:

FC =¿¿
f ¿ ] × 100

5.78−5.86 360
=[ × ] × 100
5.86 180

= -2.73%
• Therefore, discount on Krone = 2.73%

2) Find the absolute interest rate differential (i ¿¿ d) ¿ between the countries:

i d = R(U.S.) – R(Kr)

i d =¿ 3.8 %−5.7 %

i d = 1.9%
• Since the interest rate differential is less than the forward discount, borrow in the higher
interest rate country and invest in the lower interest rate country.
• Therefore, borrow Krone and invest in dollars.

5
3) Borrow Kr.1,000,000 and convert into $ at Spot rate:
S= Kr5.78/$
Numerator currency to Denominator currency: Divide
So,
1,000,000/Kr5.78 = USD$173,010

4) Invest USD$173,010 at 3.8% p.a. for 6 months and end up with:

$173,010 (1.019) = USD$176,297.

NB Interest rate = 3.8% p.a. however the forward rate is for 6 months. To get the interest
rate for 6 months;
3.8/100= 0.038 p.a.
6 months= 0.038 (6/12) = 0.019 = 1.9%

5) Convert USD$176,297 into Kr. at Forward. Rate and get:

F= Kr5.86/$
Multiply:
176,297 x 5.86 = Kr. 1,033,100

6) Repay Kr. Loan of 1,000,000 (1.0285) = Kr 1,028,500

NB Interest rate = 5.7% p.a. however the rate should be calculated for a 6-month period. To
get the interest rate for 6 months;
5.7/100= 0.057 p.a.
6 months= 0.057 (6/12) = 0.0285 = 2.85%

7)
Earn 1,033,100 – 1,028,500 = Kr.4,600

6
PART B
To find the forward rate that eliminates arbitrage, we use the interest rate parity condition, so:
F t=S o ¿

F 180=Kr 5.78 ¿

F 180 = Kr5.8347/$