What does covered interest arbitrage primarily involve?

Covered interest arbitrage primarily involves utilizing interest rate differentials with eliminated exchange rate risk. This strategy takes advantage of discrepancies between interest rates in different countries while using financial instruments, such as forward contracts, to hedge against the risk of currency fluctuations.

In practice, an investor borrows funds in a currency with a lower interest rate and invests them in a currency that offers a higher interest rate. By locking in the exchange rate through a forward contract, the investor ensures that any risks associated with changing currency values are mitigated. This enables them to profit from the difference in interest rates without exposure to potential losses stemming from currency value changes, making the process effectively "covered."

This strategy is a classic example of arbitrage, where the investor capitalizes on inefficiencies in the financial markets while maintaining a risk-free position with regard to currency values.