Welcome to professorsavings.com, we teach finance basics. Today we will teach you about covered interest arbitrage.
Hi I’m Rayfil Wong. We hope these investment concepts will help you be a better investor.
Covered interest arbitrage is a trading strategy that investors use to try to profit from the differences in two countries’ interest rates.
For example, the interest rate in the China 12 % per year while the interest rate in the United States is 5% per year.
Unfortunately unfavorable exchange rates could eliminate investor profits.
To avoid this scenario, covered interest arbitrageurs use a Forward Currency Contract so that they know what exchange rate they will receive when they convert their investment back into their original currency.
Investors need to know two things, the exchange rate when they initiate the trade. aka the spot rate. And they also need to know that they can later convert Yuan back to dollars aka forward rate.
For the trade to be profitable, this hedge must cost less than what the investor will earn from investing in the currency with the higher interest rate. Professor Savings has $100,000 to invest.
If he invests at home, he will earn 5% bringing his total to $105,000 but what if he uses covered interest arbitrage instead?
First, he converts $100,000 USD to China Yuan to get 614,070 Yuan
This investment earns 12% bringing her new total to Yuan 687,758.40
He then converts her investment back into dollars receiving $112,000
compared to $105,000 makes $7,000 USD.
But traders make money with bigger amount of dollars imagine trading with $100,000,000.
Warning: don’t forget to factor in transaction cost and tax
Professor Savings signing out. Make sure you subscribe to our channel so you can learn more about finance basics.