Uncovered interest arbitrage

Uncovered interest arbitrage is a similar strategy to covered interest arbitrage. The difference is that the currency risk is not hedged, so it is not a true arbitrage strategy.

The usual strategy is simple:

Suppose the risk free rate for currency B is higher than that for currency A, and that the difference in interest rates is greater than the expected depreciation of currency B against currency A (both over the same period).

  1. Sell currency A and buy B.
  2. Invest the amount of B bought is risk free securities.
  3. When the securities mature convert the holding of B back to A.

If currency A is borrowed, then this is called a carry trade (because the interest on the borrowed amount is a carrying cost).

Although this is not true arbitrage, it is a strategy that should usually make a profit over the risk free rate, provided the average error in the forecasts is small. Conversely, given that such profits should not so easily be come by, it can be used to derive an interest rate parity relationship.

If an uncovered interest arbitrage trade makes a profit it implies either:

  • covered interest arbitrage will also make a profit. The market should rapidly correct to eliminate an arbitrage opportunity, or
  • the trader using the uncovered interest arbitrage strategy has better forecasts than the market

While the latter may appear to be almost as unlikely as the former, it is not in fact unlikely given the evidence for forward rate bias.

Uncovered interest rate parity is the interest rate parity relationship that can be derived by assuming that uncovered interest rate arbitrage opportunities will be corrected by the market.

For more see interest rate parity.