Question

Explain why uncovered interest arbitrage is considered more risky than covered interest arbitrage.

Answer 1

Before moving the exact answer, let us see what do you mean by covered interest arbitrage and uncovered interest arbitrage.

Covered interest arbitrage

In covered interest arbitrage, a trade is trying to make use of discrepancies between the spot rates and futures or forward rate of two currencies. Here the arbitrager takes the position in the forward market and covers the risk by lending or borrowing the currencies involved at different interest rates.

Uncovered interest arbitrage

Uncovered interest arbitrage is a form of arbitrage that consist of moving from a domestic currency that carries a lower interest rate of interest of a foreign currency that provides a higher rate of interest on deposits. It is uncovered because the exchange rate risk is not hedged through a forward or future contracts.

Uncovered interest arbitrage is more risky than covered interest arbitrage because in covered arbitrage the investors, when they use a forward/future market in a future exchange rate , the investors are able to know exactly what will be the profit or loss they are going to get. But in uncovered interest arbitrage the investors are just assuming the difference between the interest rates of each country’s currency in the spot market.

So, uncovered interest arbitrage is always more risky than covered interest arbitrage.