What is COVERED INTEREST ARBITRAGE?

An ARBITRAGE transaction that takes advantage of any instance when the FORWARD PREMIUM or FORWARD DISCOUNT between two currencies does not equal the INTEREST RATE DIFFERENTIAL. When this occurs, ARBITRAGEURS can use covered interest arbitrage to generate profits until the relationships return to equilibrium. This may be done by buying one currency in the SPOT MARKET and simultaneously selling it in the FORWARD MARKET and using the spot proceeds to invest in an asset denominated in the spot currency; when the asset matures, the proceeds are used to fulfill the forward contract and the arbitrage transaction concludes with a riskfree profit.

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