Interest Arbitrage
Uncovered interest arbitrage
:
making foreign financial investments
without obtaining “cover” for exchange rate risk
Example:
Annual
3-months
U.K. 3-month Treasury
bill interest rate
10%
2.5%
U.S. 3-month Treasury
bill interest rate
6%
1.5%
Uncovered interest
differential favoring U.K.
4%
1.0%
If pound
depreciates
(from $2.00 to $1.98, or 1.0%), then investor
makes
less (zero)
If pound
appreciates
(from $2.00 to $2.02, or 1.0%), then investor
makes
more (2%)

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Interest Arbitrage
Uncovered interest arbitrage
:
making foreign financial investments
without obtaining “cover” for exchange rate risk
Example:
Annual
3-months
U.K. 3-month Treasury
bill interest rate
10%
2.5%
U.S. 3-month Treasury
bill interest rate
6%
1.5%
Uncovered interest
differential favoring U.K.
4%
1.0%
If pound
depreciates
(from $2.00 to $1.98, or 1.0%), then investor
makes
less (zero)
If pound
appreciates
(from $2.00 to $2.02, or 1.0%), then investor
makes
more (2%)
Potential for earning return, but investor exposed to exchange rate
risk