Uncovered interest arbitrage is an arbitrage trading strategy whereby an investor capitalizes on the interest rate differential between two countries. Unlike covered interest arbitrage, uncovered interest arbitrage involves no hedging of foreign exchange risk with the use of forward contracts or any other contract. The strategy is not completely riskless as an investor exposed to exchange rate fluctuations is speculating that exchange rates will remain favorable enough for arbitrage to be possible. The opportunity to earn riskless profits arises from the reality that the interest rate parity condition does not constantly hold. When foreign exchange markets or interest rates are not in a state of equilibrium, investors will no longer be indifferent among the available interest rates in two countries and will invest in whichever currency offers a higher rate of return. Economists have discovered various factors which affect the occurrence of deviations from uncovered interest rate parity and the fleeting nature of uncovered interest arbitrage opportunities, such as differing characteristics of assets, varying frequencies of time series data, and the transaction costs associated with arbitrage trading strategies.
Read more about Uncovered Interest Arbitrage: Mechanics of Uncovered Interest Arbitrage
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