Covered interest arbitrage

If there were no impediments, such as transaction costs, to covered interest arbitrage, then any opportunity, however minuscule, to profit from it would immediately be exploited by many financial market participants, and the resulting pressure on domestic and forward interest rates and the forward exchange rate premium would cause one or more of these to change virtually instantaneously to eliminate the opportunity.

Economists Robert M. Dunn, Jr. and John H. Mutti note that financial markets may generate data inconsistent with interest rate parity, and that cases in which significant covered interest arbitrage profits appeared feasible were often due to assets not sharing the same perceptions of risk, the potential for double taxation due to differing policies, and investors' concerns over the imposition of foreign exchange controls cumbersome to the enforcement of forward contracts.

The researchers found evidence for substantial variation in covered interest rate parity deviations from equilibrium, attributed to transaction costs and market segmentation.

Batten and Szilagyi point out that the modern reliance on electronic trading platforms and real-time equilibrium prices appear to account for the removal of the historical scale and scope of covered interest arbitrage opportunities.

Their empirical analysis demonstrates that positive deviations from covered interest rate parity indeed compensate for liquidity and credit risk.

After accounting for these risk premia, the researchers demonstrated that small residual arbitrage profits accrue only to those arbitrageurs capable of negotiating low transaction costs.