Covered interest arbitrage is the investment strategy where an investor buys a financial instrument denominated in a foreign currency, and hedges his foreign exchange risk by selling a forward contract in the amount of the proceeds of the investment back into his base currency. The proceeds of the investment are only known exactly if the financial instrument is risk-free and only pays interest once, on the date of the forward sale of foreign currency. Otherwise, some foreign exchange risk remains. Financial instruments package financial capital in readily tradeable forms - they do not exist outside the context of the financial markets. ... Other uses of the word hedge. ... A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. ...

Similar trades using risky foreign currency bonds or even foreign stock may be made, but the hedging trades may actually add risk to the transaction, e.g. if the bond defaults the investor may lose on both the bond and the forward contract.

Bold text'Bold text'Bold text==Example==

In this example the investor is based in the United States and assumes the following prices and rates: spot USD/EUR = $1.2000, forward USD/EUR for 1 year delivery = $1.2300, dollar interest rate = 4.0%, euro interest rate = 2.5%. If you are trading FX Spot you are buying one currency with a different currency for immediate delivery and not future delivery. ... A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. ...

• Exchange USD 1,200,000 into EUR 1,000,000
• Buy EUR 1,000,000 worth of euro-denominated bonds
• Sell EUR 1,025,000 via a 1 year forward contract, to receive USD 1,260,750, i.e. agree to exchange the euros back into US dollars in 1 year at today's forward price.
• This set of transactions can be viewed as having an effective dollar interest rate of (1,260,750/1,200,000)-1 = 5.1%
• Alternatively, if the USD 1,200,000 were borrowed at 4%, USD 1,248,000 would be owed in 1 year, leaving an arbitrage profit of 1,260,750 - 1,248,000 = USD 12,750 in 1 year.

Models

Financial models such as interest rate parity and the cost of carry model assume that no such arbitrage profits could exist in equilibrium, thus the effective dollar interest rate of investing in any currency will equal the effective dollar rate for any other currency, for risk-free instruments. TANSTAAFL The Interest Rate Parity is the basic identity that relates interest rates and exchange rates. ... The cost of carry refers to the lost oppportunity cost of purchasing a particular security rather than an alternative. ... TANSTAAFL is an acronym for the adage There Aint No Such Thing As A Free Lunch, popularized by science fiction writer Robert A. Heinlein and promulgated in his 1966 novel The Moon Is a Harsh Mistress, which deals with a libertarian utopia. ...

See also

• Cost of Carry
• Interest Rate Parity
• TANSTAAFL

The cost of carry refers to the lost oppportunity cost of purchasing a particular security rather than an alternative. ... The Interest Rate Parity is the basic identity that relates interest rates and exchange rates. ... TANSTAAFL is an acronym for the adage There Aint No Such Thing As A Free Lunch, popularized by science fiction writer Robert A. Heinlein and promulgated in his 1966 novel The Moon Is a Harsh Mistress, which deals with a libertarian utopia. ...

External links

• Disk Lectures MBA level audio lecture with slideshow on Foreign Exchange