Covered interest arbitrage is a trading strategy that investors use to try to profit from the differences in two countries’ interest rates. For example, the interest rate in the Euro zone might be 15% per year while the interest rate in the United States is 5% per year.
Unfortunately, unfavorable exchange rates could eliminate investor profits. To avoid this scenario, covered interest arbitrageurs use a Forward Currency Contract so that they know what exchange rate they will receive when they convert their investment back into their original currency.
Investors need to know two things, the exchange rate when they initiate the trade. For example, EUR1 equals $1.39, the spot rate and they also need to know that they can later convert Euros back dollars at a rate of EUR1 equals $1.35, the forward rate.
For the trade to be profitable, this hedge must cost less than what the investor will earn from investing in the currency with the higher interest rate. Angela has $1 million to invest.
If she invested home, she will earn 5% bringing her total to $1,050,000. But what if she uses covered interest arbitrage instead?
First, she converts $1 million to Euros to get EUR721,500, this investment earns 15% bringing her new total to EUR829,725.
She then converts her investment back into dollars receiving $1,120,129. Opportunities to profit from covered interest arbitrage are rare especially in highly active markets where all market participants are equally informed.
Also the market usually brings any imbalances back to equilibrium when investors who identifies such an opportunity plays a flurry of trades in an attempt to make a quick riskless profit. Their profits are typically small and taxes and transaction costs can eliminate gains from covered interest arbitrage.