Covered and uncovered interest arbitrage? - Answers

Covered arbitrage refers to when an investor buys a certain currency at its spot rate (i.e. $100,000 @ US$1 = £1.05) but then also purchases/enters into contract for a forward rate investment back at the same time (i.e. 1 year forward rate of US$1 = £1.10). Once they get their monies in £ they make their investment in the foreign market of £105,000. (i.e. Euro bond rates of 16%) for a year. So at the end of the year they will have 16% return so now £121,800. They then get the forward exchange rate again ended up with US$110,727.27 after the year, so a profit of $10,727.27. Uncovered arbitrage is much the same, except that at the start they do not enter into a contract for a forward exchange rate back, meaning that they just have to invest back at the spot rate that is available to them at the end of the year long investment. This is no-where near as safe, but contrary to this there is a chance that the spot exchange rate at the end may be considerably higher or lower depending upon the market at the time and therefore meaning that an uncovered arbitrage may end up making you considerably more money, or the exact opposite.