Let’s say we borrow USD 2,000,000 from an American Bank. What is the interest rate in the US now?
Let’s use 1.11%. Thus, in 1 year I have to return to the American Bank USD 2,000,000 (1 + 1.11/100).
= USD 2022000
Having borrowed the USD 2,000,000, we now want to invest in Malaysia/Turkey/Australia. I will use Malaysia for this example. What is the 1-year Malaysian interest rate?
Let’s say we invest in CIMB and are promised a 3.95% return in a year. However, to achieve this, we need MYR. So we go to FX spot market and buy MYR. Currently, USDMYR = 4.32. Thus, our USD 2,000,000 will fetch us MYR 8,640,000.
This amount is invested in CIMB. In 1 year, we receive: MYR 8,640,000 (1+3.95/100)
= MYR 8,981,280.
We have to pay the American Bank back in USD. Assuming the 4.32 exchange rate holds, it will be worth USD (8,981,280/4.32) = USD 2,079,000.
Our arbitrage profit is 2,079,000 – 2,022,000 = USD 57,000.
However, this will only work if the same 4.32 exchange rate holds. Thus, FX risk can be hedged/mitigated only if the FX rate doesn’t fluctuate by a rate resulting in a loss of value by USD 57,000 or more.
Therefore, the investor will have to find a suitable forward contract, with a rate below 4.49.
How did we find the value of 4.49? 8,981,280 / 2,000,000 = 4.49. This means, for any forward/future contract below 4.49, covered interest arbitrage will be possible, and the investor will make sure profit.