COVER IN MONEY MARKET

(COVERED INTEREST ARBITRAGE)

 COVER IN MONEY MARKET
(COVERED INTEREST ARBITRAGE
Currency rate determined by the major factors
such as interest and inflation. Interest rates are
also influenced by inflation. Between 2
currencies there should not be difference in
interest rates and their spot and forward
exchange rates. If there are differences in
interest and exchange rates it can be exploited
to one’s advantage. Receiver or payer in a
foreign currency can take benefits in these
differences through arbitrage process.
 Arbitrage Process
1. Borrow in 1 currency and pay interest on
that.
2. Convert that currency in another currency at
spot rate.
3. Invest in converted currency to earn interest.
4. Receive invested money on maturity with
interest.
5. Subsequently convert the currency on to a
forward date and rate and repay the loan
with interest.
 example
An Indian importer has to pay $100000 after 3
months.
ER spot Rs. 61. Forward Rate (3 months) Rs.61.5.
Interest Rate- Ruppes 8% and Dollar 6%
Calculate arbitrage profits or loss?
Solution:
Interest rate differential= 8%-6% = 2%
Spread = Forward rate- Spot Rate 12 100
Spot Rate Months
= 61.5- 61.0 12 100 = 3.28%
61.0 3

Spread percentage of 3.28% is higher compared

interest rate differential of 2%.
Forward rate of Dollar is higher compared to higher
interest rate of india.
Person who is exposed in foreign currency (dollars)
can borrow in rupees and invest in dollar forward
market and there by can benefit from operation
Arbitrage process
• Indian has to pay $100000 in 3 months
i.e 61*100000 = Rs 6100000
• Importer borrows Rs 6100000 at 8% for 3 months
Interest for 3 months- 6100000*8/100*3/12 = 122000
A) Money repayable after 3 months with interest
6100000+122000 = 6220000
• He Converts Rs6100000 in dollars at spot rate Rs 61 and gets
$100000
• He deposits these dollars for 3 months to earn interest a 6%
= 100000*6/100*3/12 = $1500
• Refund of dollars deposit with interest $101500
B) Conversion of dollar into rupees at forward rate $101500
101500*61.5 = 6242250
less return of loan with interest = 6220000
Profit on arbitrage (B-A) 22250
• Difference between spot rate and forward rate
of dollar is 0.50 (Rs61.50-61.0)
• Exposure of importer in Rs = 0.50*100000
= 50000
less: profit on arbitrage = 22250
uncovered balance of exposure 27750
Importers Loss is covered to the extent of Rs.
22250 due to money market operation.
Problem
An Indian has to receive Euro 100000 after 90
days. Present rate of Euro 80.00 and forward
rate 79.00.
Exporter in order to cover the loss or exposure
decides to enter into money market. Interest
rate on Euro is 6% and Rupees is 8%
Work out arbitrage profit or loss?