Covered Arbitrage

Covered arbitrage definition


The most common covered arbitrage definition relates to the international FOREX market; it refers to a transaction which derives forward cover for its foreign exchange risk by means of purchasing an offsetting cash commodity in order to cover the future obligation. By hedging the investment in this manner, investors may be able to profit on both aspects of the transaction while shielding themselves from unexpected downturns or risks for the duration of the investment.


How arbitrage works


To understand covered arbitrage, it’s essential to first define arbitrage as it is used within the FOREX markets. Arbitrageurs are basically middle-men in the FOREX markets. They locate buyers who are willing to pay a certain price for a given commodity, financial security, currency, and then purchase that currency from sellers who are offering it at a lower price. This allows the arbitrageur to make a guaranteed profit without significant risk. These transactions usually are time-sensitive, requiring quick action on the part of the arbitrageur in order to gain the available profits. Arbitrage is not considered speculative, since in most cases the exact amount of profit is known in advance of the transaction.

Covered interest arbitrage


In most cases, covered interest arbitrage is a transaction that includes a fixed-interest foreign currency financial security and an accompanying forward agreement that offsets the risk of loss due to a change in the value of the underlying currency. Typically the financial security involved is a government bond, which offers a fixed and definite payment amount at the end of its term. By combining this with a forward contract to sell the currency at the current rates, investors can ensure that the foreign currency payment derived at the end of the term is not lessened due to fluctuations in the FOREX market.

Uncovered interest arbitrage


If no forward agreement accompanies the purchase of the foreign financial security, then the transaction is called uncovered interest arbitrage; most analysts would argue that this is not a true arbitrage strategy, since there is a significant risk of losing part or all of the expected profit if the value of the foreign currency fluctuates downward significantly. 
Tim Ord
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