Uncovered interest arbitrage
What is uncovered interest arbitrage?
It’s an investment strategy where you convert a domestic currency with a low interest rate to a foreign currency with higher interest to try to profit from it. It’s ‘uncovered’ because the exchange rate risk isn’t hedged through a forward contract.
Where have you heard about uncovered interest arbitrage?
This form of arbitrage has become quite popular in various sectors of the financial markets, but it’s less common than covered interest arbitrage, which doesn't carry as much risk as it's protected with a forward contract.
What you need to know about uncovered interest arbitrage.
Suppose the interest rate for the euro is higher than the British pound. You could sell your pounds to buy euros, and use them to buy securities such as government bonds. When the bonds mature, the euros are then converted back to pounds.
While this strategy can be profitable, it can also be risky as exchange rates fluctuate. You’re speculating that rates will remain in your favour for you to gain, but adverse currency movements can eradicate all the profits and even lead to negative returns.