Covered Interest Arbitrage - Calculations & Discussion - Essay Example

 ‘Covered Interest Arbitrage is buying a country’s currency spot and selling that country’s currency forward, to make a net profit from the combination of the difference in interest rates between countries and the forward premium on that country’s currency.’ (Pugel, 2008) The banks and investors can take advantage of the coverage in arbitrage by investing in foreign currency and locking the position and eliminating the foreign exchange risk by entering into a forward contract. The forward contract involves buying the home currency at a future date equal to the amount received of the foreign currency at that future date.  The exchange rate at which the two currencies will be exchanged in the forward contract at the preset future date is fixed and thus the investor is saved from the risk of adverse exchange rate movements. This method eliminates the downside risk but also puts a cap on the profits that could have been received if the exchange rate moved favorably instead of unfavorably.

These versions include the law of one price, absolute PPP, and relative PPP. ‘In relative terms, PPP says that exchange rate moves in line with the interest rate differential.’ (Rochon & Vernengo, 2001) On a long-term basis, the lower the inflation the more the currency appreciates, and the higher the rate of inflation the greater the magnitude of the currency’s depreciation.

In terms of Ireland and the US, the exchange rate went down from $1/€0.70 to $1/€0.65 for the US dollar indicating the depreciation of the US dollar in terms of the Euro and hence signaling inflation in the US market. On the other side of the picture, an appreciation of the Euro signifies low inflation and high growth in the Irish market. In terms of goods the US dollar could buy € 0.7 worth of goods one year back and now it can afford only € 0.65 for the same dollar. Thus the US dollar depreciated indicating inflation in the US market and showing an appreciation of the Euro.