The forward rate of a currency for a specified future date is determined by the interaction of demand for the contract (forward purchases) versus the supply (forward sales). Forward rates are quoted for some widely traded currencies (just below the respective spot rate quotation) in the Wall Street Journal. Financial institutions that offer foreign exchange services set the forward rates, but these rates are driven by the market forces (demand and supply condition). In some cases, the forward rate may be priced at a level that allows investors to engage in arbitrage. Their actions will affect the volume of orders for forward purchases of forward sales of a particular currency, which in turn will affect the equilibrium forward rate. Arbitrage will continue until the rate is aligned where it should be, and that at that point arbitrage will no longer be feasible. This arbitrage process and its effects on the forward rate are described next.
Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries while covering your exchange rate risk with a forward contract. The logic of the term covered interest arbitrage becomes clear when it is broken into two parts: “interest arbitrage” refers to the process of capitalizing on the difference between interest rates between countries; “covered” refers to hedging your position against exchange rate risk. Covered interest arbitrage is sometimes interpreted to mean that the funds to be invested are borrowed locally. In this case, the investors are not tying up any of their own funds. In another interpretation, however, the investors use their own funds. In this case, the term arbitrage is loosely defined since there is a positive dollar amount invested over a period of time. The following discussion is based on this later meaning of covered interest arbitrage; under either interpretation, however, arbitrage should have a similar impact on currency values and interest.