Interest Arbitrage

Interest arbitrage is the transfer of funds from one currency to another to take advantage of higher rates of return. In order to make the foreign investment, the domestic (sometimes called home) currency must be converted into the foreign currency. Then, when the investment matures or is liquidated, the foreign currency must be reconverted back into the domestic currency. A foreign exchange risk arises because during the period of the investment, the spot exchange rate of the foreign currency may fall so that the investor gets back fewer domestic currency units than were originally paid. This fall may wipe out some or all of the extra interest earned on the foreign over the domestic investment and may even lead to an actual loss. See also covered interest arbitrage.