Mechanics of Uncovered Interest Arbitrage
An arbitrageur executes an uncovered interest arbitrage strategy by exchanging domestic currency for foreign currency at the current spot exchange rate, then investing the foreign currency at the foreign interest rate.
For example, consider that an investor with $5,000,000 USD is considering whether to invest abroad using an uncovered interest arbitrage strategy or to invest domestically. The dollar deposit interest rate is 3.4% in the United States, while the euro deposit rate is 4.6% in the euro area. The current spot exchange rate is 1.2730 $/€. For simplicity, the example ignores compounding interest. Investing $5,000,000 USD domestically at 3.4% for six months ignoring compounding, will result in a future value of $5,170,000 USD. However, exchanging $5,000,000 dollars for euros today, investing those euros at 4.6% for six months ignoring compounding, and exchanging the future value of euros for dollars at the future spot exchange rate (which for this example is 1.2820 $/€), will result in $5,266,976 USD, implying that investing abroad using uncovered interest arbitrage is the superior alternative if the future spot exchange rate turns out to be favorable.
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