What is Covered Interest Arbitrage?

Covered interest arbitrage is a strategy in which an investor uses a forward contract to hedge against exchange rate risk. Covered interest rate arbitrage is the practice of using favorable interest rate differentials to invest in a higher-yielding currency, and hedging the exchange risk through a forward currency contract.

Covered interest arbitrage is only possible if the cost of hedging the exchange risk is less than the additional return generated by investing in a higher-yielding currency - hence the word, arbitrage. 


Covered Interest Arbitrage

Basics of Covered Interest Arbitrage

Returns on covered interest rate arbitrage tend to be small, especially in markets that are competitive or with relatively low levels of information asymmetry. Part of the reason for this is the advent of modern communications technology. Research indicates that covered interest arbitrage was significantly higher between GBP and USD during the gold standard period due to slower information flows.



Key Takeaways

  • Covered interest arbitrage uses a strategy of arbitraging the interest rate differentials between spot and forward contract markets in order to hedge interest rate risk in currency markets.
  • This form of arbitrage is complex and offers low returns on a per trade basis. But trade volumes have the potential to inflate returns.

Example of Covered Interest Arbitrage

Note that forward exchange rates are based on interest rate differentials between two currencies. As a simple example, assume currency X and currency Y are trading at parity in the spot market (i.e. X = Y), while the one-year interest rate for X is 2% and that for Y is 4%. Therefore, the one-year forward rate for this currency pair is X = 1.0196 Y (without getting into the exact math, the forward rate is calculated as [spot rate] times [1.04 / 1.02]).



A savvy investor could therefore exploit this arbitrage opportunity as follows -
