Covered Interest Rate Arbitrage

An arbitrage approach which consists of borrowing currency A, exchanging it for currency B, investing currency B for the duration of the loan, and, after taking off the forward cover on maturity, showing a profit on the entire set of deals. It is based on the theorem of interest rate parity (one of the key theoretical economic relationship) which says that the return on a hedged foreign investment will just equal the domestic interest rate on investments of identical risk. When the covered interest rate differential between the two money market is zero, there is no arbitrage incentive to move funds from one market to another.

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