Interest arbitrage has two variants, namely, covered and uncovered.
(a) Uncovered Interest Arbitrage:
In this case, shifting of funds for taking advantage of higher interest earnings is not accompanied with steps to protect against exchange rate risk, that is, the risk of depreciation of foreign currency when the investments mature.
Consequently, the additional earning of interest is subject to a loss (or additional gain) on account of exchange rate variation. As a result, interest arbitrage is mostly covered.
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(b) Covered Interest Arbitrage:
It is natural that investors who are keen to take advantage of interest rate differential between two financial centres and are ready to move their funds abroad for this purpose, would also protect themselves against exchange rate risk.
Therefore, they buy foreign currency in the spot market for making investment abroad, and at the same time, sell that foreign currency in the forward market.
This simultaneous buying spot and selling forward of foreign currency is known as swap of foreign currency. And this currency swap for making short term investment abroad is known as covered interest arbitrage.
Normally, the currency with a higher interest rate is at a forward discount, the net return of the interest arbitrageur is somewhat less than the interest earned. It is equal to the interest earned minus the forward discount on the foreign currency.
ADVERTISEMENTS:
Here also, as in the case of currency arbitrage, the process of interest arbitrage continues till the interest rate differential is wiped out. The reason for this has already been described above.