I have completed the Currency Exchange Rate Chapter (Eco) but the concept of Covered Interest Arbitrage under IRP is still not clear for me. I have struggled in the mocks regarding the same sub topic.
Kindly guide me how can I make my understanding of it better. And there are any examples with explanation regarding the same, they are utmost welcome.
Covered Interest Arbitrage (CIA) is a financial strategy that takes advantage of discrepancies in interest rates and currency exchange rates between two countries. It involves borrowing funds in one currency, converting them into another currency, investing them in that country, and then converting the investment proceeds back into the original currency to repay the borrowed amount. The goal is to profit from the interest rate differential and ensure that the currency exchange risk is fully hedged.
To explain CIA using an example, let’s consider a situation where there are two countries, Country A and Country B, with different interest rates and exchange rates.
Suppose the interest rate in Country A is 5%, while the interest rate in Country B is 2%. Additionally, the spot exchange rate is such that 1 unit of Country A’s currency (A currency) can be exchanged for 1.5 units of Country B’s currency (B currency).
Here are the steps involved in Covered Interest Arbitrage:
In this example, the investor made a profit of 20,000 A currency (1,020,000 A currency – 1,000,000 A currency) by taking advantage of the interest rate differential and the currency exchange rate. The investor was able to earn a higher interest rate in Country B (2%) compared to Country A (5%), while simultaneously ensuring that the currency exchange risk was fully hedged by converting the investment proceeds back into the original currency.
It’s important to note that Covered Interest Arbitrage is typically a short-lived opportunity as market forces tend to quickly adjust interest rates and exchange rates to eliminate such discrepancies.