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Covered Interest Arbitrage

Covered interest arbitrage is a strategy in which investors exploit differences in interest rates between two countries while hedging against exchange rate risk using forward contracts. By borrowing in a country with lower interest rates and investing in a country with higher rates, and simultaneously locking in the exchange rate through a forward contract, the investor earns a risk-free profit. The "covered" aspect of the strategy refers to the use of forward contracts to eliminate currency risk.

Example

An investor borrows funds in Japan at a low-interest rate, converts the money into U.S. dollars, and invests in U.S. bonds with a higher interest rate, simultaneously locking in a future exchange rate using a forward contract.

Key points

• Covered interest arbitrage involves exploiting interest rate differences between countries while hedging currency risk with forward contracts.

• The strategy generates risk-free profits by locking in exchange rates and taking advantage of higher interest rates abroad.

• Forward contracts are used to hedge against exchange rate fluctuations.

Quick Answers to Curious Questions

Investors borrow in a country with low interest rates, invest in a country with higher rates, and use forward contracts to hedge against exchange rate risk, securing risk-free profits.

Forward contracts lock in a specific exchange rate for future transactions, eliminating the risk of currency fluctuations affecting the investor’s returns.

While the strategy is typically considered low risk, factors like interest rate changes or issues with the forward contract could impact profitability.