The flow of money for the purpose of taking advantage of a covered interest differential is known as ________.
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A. B. C. D. E.D
The flow of money for the purpose of taking advantage of a covered interest differential is known as covered interest arbitrage'
The correct answer to the question is D. covered interest arbitrage.
Covered interest arbitrage refers to the process of taking advantage of a covered interest differential. Let's break down the components of this concept to better understand it:
Interest Rate Differential: An interest rate differential is the difference in interest rates between two countries. It occurs when the interest rates offered by two currencies differ. For example, let's consider two countries, Country A and Country B. If the interest rate in Country A is higher than the interest rate in Country B, there is a positive interest rate differential.
Covered Interest Differential: The covered interest differential specifically refers to the difference in interest rates between two countries, while taking into account the forward exchange rate. The forward exchange rate is a rate at which two parties agree to exchange currencies in the future. By incorporating the forward exchange rate, any potential gains or losses due to changes in exchange rates can be covered or mitigated.
Covered Interest Arbitrage: Covered interest arbitrage involves taking advantage of the covered interest differential by borrowing in a currency with a lower interest rate and investing in a currency with a higher interest rate, while covering the exchange rate risk using a forward contract. The process involves the following steps:
a. Borrowing: The investor borrows funds in the currency with the lower interest rate. This allows them to benefit from the lower cost of borrowing.
b. Converting: The borrowed funds are converted into the currency with the higher interest rate.
c. Investing: The converted funds are invested in an instrument, such as a bond or deposit, that provides a higher interest rate.
d. Forward Contract: To mitigate the exchange rate risk, the investor enters into a forward contract to lock in a future exchange rate for converting the invested currency back to the original currency.
e. Repayment and Conversion: At the end of the investment period, the investor repays the borrowed funds, using the proceeds from the investment. They then convert the invested currency back to the original currency using the forward contract.
f. Profit or Loss: The investor earns a profit if the interest earned from the investment, when converted back to the original currency, exceeds the cost of borrowing and any exchange rate losses. Conversely, a loss occurs if the interest earned is insufficient to cover the borrowing costs and any exchange rate losses.
In summary, covered interest arbitrage involves taking advantage of the interest rate differentials between two countries while using forward contracts to cover the exchange rate risk. By borrowing in a currency with a lower interest rate and investing in a currency with a higher interest rate, investors aim to generate a profit from the interest rate differentials.