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A Comprehensive Guide to Covered Interest Arbitrage

26 Sep 2023

Covering interest is one of the most popular forex trading strategies that most forex traders tend to rely on. If you are into currency exchange trading, you must have heard about covered interest arbitrage. But if you do not know about it, keep reading. Here, we will discuss everything you need to know about covered interest arbitrage.

What is Covered Interest Arbitrage?

Before you learn about covered interest arbitrage, you must know about the interest arbitrage investment strategy. Interest arbitrage is a forex trading strategy where you convert your investment capital into a different (with a higher interest rate) country's currency and invest there. 

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This type of investment also involves the risk of constant exchange rate changes. Herein comes the covered interest arbitrage, incorporating a forward contract with the traditional interest arbitrage strategy to nullify the exchange rate risk and hedge profit. 

What are the Risks Associated with Covered Interest Arbitrage?

The covered interest arbitrage strategy is no longer practical to prevent the risks of forex investment due to the above-mentioned associated risk factors. The only way to ensure the most effective covered interest arbitrage strategy is by cutting the transaction cost below the market rates. 

However, here are some risks associated with covered interest arbitrage:

  • Varied tax treatments
  • Cost of transaction
  • Foreign exchange controls
  • Possibility of spillage in the process
  • Inflexibility of supply and demand chain
  • Inconsistent or constantly changing tax agreements
  • Lack of fixed regulations

Key Differences between Uncovered and Covered Interest Arbitrage 

Many new forex investors get confused between covered and uncovered interest arbitrage strategies. So, you should learn about the fundamental difference between covered and uncovered interest arbitrage, as you have learned that a covered interest arbitrage strategy always uses a forward or future rate contract, which helps in potential hedging. 

In contrast, the uncovered interest arbitrage strategy does not use the future or forward interest rate. Instead, it considers the predicted rates (leading to anticipated future interest rates). As a result, it uses the assumed future rates instead of the actual future or forward rate.

Investors profit from covered interest arbitrage when they borrow from a low-interest-rate currency to invest in a high currency rate. However, in an uncovered interest arbitrage, investors do not get this advantage. 

Final Thoughts

The covered interest arbitrage strategy is a primary forex or currency exchange trading strategy. It is an interest arbitrage strategy that includes a forward contract to secure the returns from potential losses (due to changing exchange rates). 

Above, we have covered the essential details of covered interest arbitrage, including what it is, the associated risks, and the difference between covered and uncovered interest arbitrage strategies, to help you with your investment strategy. 

 

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