How does banks use "Covered interest arbitrage to protect themselves© BrainMass Inc. brainmass.com October 9, 2019, 8:08 pm ad1c9bdddf
How does banks use "Covered interest arbitrage to protect themselves
Answer: Covered interest arbitrage is the transfer of liquid funds from one monetary center (and currency) to another to take advantage of higher rates of return or interest, while covering the transaction with a forward currency hedge. Since the foreign currency is likely to be at a forward discount, the investor loses on the foreign transfers currency transaction per se. But if the positive interest differential in favor of the foreign money center exceeds the forward discount on the foreign currency (when both are expressed in percentage per year), it pays to make the foreign investment.
Covered Interest Arbitrage when Foreign Interest Rates are Higher than U.S. Interest Rates:
For example, When interest rates in Germany are greater than in the United States (or elsewhere), a U.S. investor can exchange dollars for dms today and use these dollars to buy a 3-month T-bill in Frankfurt at 12%. He earns 4% more per year (or 1% more per 3 months) than if he had used his dollars to buy a 3-month T-bill in the New York at 8%. If the spot rate today is $.333 and the spot rate in three months is $.330, he will lose $.003 or 1% on the foreign exchange conversion. The annualized 4% gain from the German ...
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