COVERED INTEREST ARBITRAGE Explain the concept of covered interestarbitrage and the scenario necessary for it to be plausible.

Covered interest arbitrage is a financial strategy that financial market participants use to take advantage of differences in interest rates between two countries. The strategy involves borrowing money in a country with a lower interest rate, then investing that money in a country with a higher interest rate, while simultaneously using a forward contract to eliminate the risk of exchange rate fluctuations.

Here are the steps involved in covered interest arbitrage:

1. Borrow money in a country with a lower interest rate. For example, if the interest rate in the US is 2%, an investor could borrow money here.

2. Convert the borrowed money into a foreign currency. For instance, if the investor borrowed in US dollars, they could convert this into euros.

3. Invest the money in the foreign country with a higher interest rate. If the interest rate in Germany is 4%, the investor could invest the euros here.

4. Simultaneously enter into a forward contract to sell the foreign currency (euros) in the future. This is to eliminate the risk of the euro depreciating against the dollar by the time the investment matures.

5. When the investment matures, the investor will have more money than they borrowed due to the higher interest rate in the foreign country. They can then use the forward contract to convert the euros back into dollars at a predetermined rate, ensuring they can repay the original loan regardless of any changes in the exchange rate.

For covered interest arbitrage to be plausible, there must be a difference in interest rates between two countries, and the investor must be able to borrow money in the lower interest rate country and invest in the higher interest rate country. Additionally, the investor must be able to enter into a forward contract to eliminate exchange rate risk.