International interest rate arbitrage: Study on a novel strategy

Abstract

This study examines the time-varying excess returns in an international interest rate arbitrage (IIRA) strategy, with a particular emphasis on these excess returns. Unlike traditional carry strategies that typically match funding and investment bonds' maturities or currencies, our novel IIRA strategy is a dynamically adjusted approach involves funding with a 1-year low-yield treasury bond while investing in 2- to 10-year high-yield bonds in foreign currencies. An analysis of Sharpe ratios, foreign exchange (FX), and yield excess return shows variations in the joint expectations hypothesis of the term structure (EHTS) and the uncovered interest rate parity (UIRP) lead to profits. However, the international strategies perform worse than the domestic carry strategies. Predictive factors, such as the Cochrane–Piazzesi, show limited effectiveness due to FX volatility. Therefore, future studies should examine more predictability factors.