Covered interest arbitrage

Covered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries by using a forward contract to cover (eliminate exposure to) exchange rate risk.[1] Using forward contracts enables arbitrageurs such as individual investors or banks to make use of the forward premium (or discount) to earn a riskless profit from discrepancies between two countries' interest rates.[2] The opportunity to earn riskless profits arises from the reality that the interest rate parity condition does not constantly hold. When spot and forward exchange rate markets are not in a state of equilibrium, investors will no longer be indifferent among the available interest rates in two countries and will invest in whichever currency offers a higher rate of return.[3] Economists have discovered various factors which affect the occurrence of deviations from covered interest rate parity and the fleeting nature of covered interest arbitrage opportunities, such as differing characteristics of assets, varying frequencies of time series data, and the transaction costs associated with arbitrage trading strategies.

  1. ^ Madura, Jeff (2007). International Financial Management: Abridged 8th Edition. Mason, OH: Thomson South-Western. ISBN 978-0-324-36563-4.
  2. ^ Pilbeam, Keith (2006). International Finance, 3rd Edition. New York, NY: Palgrave Macmillan. ISBN 978-1-4039-4837-3.
  3. ^ Moffett, Michael H.; Stonehill, Arthur I.; Eiteman, David K. (2009). Fundamentals of Multinational Finance, 3rd Edition. Boston, MA: Addison-Wesley. ISBN 978-0-321-54164-2.