Uncovered Interest Arbitrage

Uncovered interest arbitrage is a currency trading strategy where an investor borrows in a currency with a lower interest rate and invests in a currency with a higher interest rate, without using a forward contract to hedge against exchange rate fluctuations. The investor earns the difference in interest rates but is exposed to the risk of unfavorable currency movements that could negate any potential gains.

Example

An investor borrows U.S. dollars at a low interest rate and converts them to Brazilian reais to invest in Brazilian bonds with a higher interest rate, hoping to profit from the interest rate differential while taking on currency risk.

Key points

• A currency arbitrage strategy involving borrowing in a low-interest-rate currency and investing in a higher-interest-rate currency.

• Exposes the investor to exchange rate risk, as no forward contract is used to hedge.

• Profit depends on interest rate differentials and currency movements.

Quick Answers to Curious Questions

What risk does uncovered interest arbitrage expose investors to?

Investors are exposed to exchange rate risk, meaning that adverse currency movements could offset the interest rate differential.

How does uncovered interest arbitrage differ from covered interest arbitrage?

Uncovered interest arbitrage does not hedge against currency fluctuations with a forward contract, whereas covered interest arbitrage uses forward contracts to lock in exchange rates.

Why might an investor choose uncovered interest arbitrage despite the risks?

An investor may expect favorable currency movements or seek higher potential returns from the interest rate differential, even with the added currency risk.