![Covered Interest rate arbitrage can be described as a strategy in which an investor hedges against exchange rate risk by usin](//img.homeworklib.com/images/e3c06646-2dea-4c85-b78f-82d43b6a1caf.png?x-oss-process=image/resize,w_560)
Covered Interest rate arbitrage can be described as a strategy in which an investor hedges against exchange rate risk by using a forward contract, that would be investing in higher yielding currency using favorable interest rate differentials and then hedging the risk through forward contract Let's take an example of two countries, US and UK, assuming, in spot market, these countries are trading at parity, such that one-year interest rate in UK is 4% and in US is 2%. One year forward contract for currencies of these countries would be $ = [1.04/1.02] £, that is for one dollar, the investor will get 1.0196£ Swap points is the difference between the forward rate and spot rate, such that swap points required to buy $ one year from now in the forward market is 125 points. An investor can engage in covered interest arbitrage by borrowing $ at 2% per annum, let's say $100,000, such that total loan repayment should be $102,000. Convert these $100,000 into £ at the spot rate 1.00. Now, deposit these £100,000 at 4% rate and enter into a forward contract which will convert the whole mature amount into $ at the one year forward rate of $ = [1.0125] £ After a year, the investor will get £104,000 convert into $ at the forward rate of 1.0125, which would be, $102,716, keep the difference of $716 so now the investor will repay the loan of $102,000 and will That's how an investor can engage in covered interest rate arbitrage Also, this is possible only when the interest rate differential is greater than the cost of hedging If people tend to do this, then this will tend to align interest rates across the globe between every currency as demand will increase while supply remains the same, so price would increase resulting in decreased interest rate differentials This statement is accepted such that it is known that due to various factors, interest rates are different in different countries and varies across the globe. These factors could be risk, inflation, expectations, etc