Covered interest arbitrage

Covered interest arbitrage is a trade in a foreign currency fixed interest security (usually a government bond) together with a matching forward agreement to hedge the currency risk.

The trade make use of a inconsistencies between interest rates and forward rates to make a riskless profit.

The possibility of interest rate arbitrage together with the no arbitrage requirement can be used to deduce a relationship between currency depreciation and inflation. For a description of this and a simple example of an arbitrage trade see interest rate parity.

Covered interest arbitrage is a true arbitrage strategy. This is not true of uncovered interest arbitrage which leaves the trader exposed to currency risk.