Definition
Covered interest arbitrage is a trading strategy that seeks to profit from interest rate differences between two countries while removing currency risk. A trader borrows money in a currency with a low interest rate, converts it to a currency with a higher interest rate, and invests it there. At the same time, the trader locks in a future exchange rate using a forward contract to convert the investment back to the original currency when it matures. This “covering” eliminates the uncertainty of future exchange rate movements. The profit comes from earning the higher foreign interest rate while knowing exactly what the investment will be worth when converted back.
The strategy works only when interest rate gaps aren't fully reflected in forward exchange rates, creating temporary pricing inefficiencies that traders can exploit. The forward points added to or subtracted from the spot rate to determine the forward exchange rate directly reflect the interest rate differential between the two currencies. When markets are functioning efficiently, covered interest parity should hold, meaning the forward premium or discount exactly offsets the interest rate differential, leaving no arbitrage opportunity.
In short: Covered interest arbitrage captures risk-free profit from international interest rate differences by hedging currency exposure with forward contracts.
Example in Action
To understand how covered interest arbitrage works in practice, it helps to walk through a real transaction from start to finish.
A trader borrows funds in a low-interest currency, converts them at the spot rate, deposits the money abroad at a higher rate, and locks in a forward contract.
At maturity, they convert back, repay the loan, and pocket the difference as profit.
Alternatively, traders may use FX swaps to execute both the spot and forward legs simultaneously, streamlining the transaction into a single instrument.
Why It Matters
For traders across African markets, understanding covered interest arbitrage isn't just academic—it's a window into how currency markets actually function and why certain opportunities appear or vanish.
This strategy reveals market efficiency, showing where transaction costs, regulatory controls, and interest rate gaps create real barriers.
It explains why Kenyan, Nigerian, or South African traders face different forex conditions than their global counterparts, highlighting structural realities affecting cross-border capital flows.
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