Functions of the forward exchange market: Covered Interest Arbitrage

One of the most-common transactions in the international financial system arises when an investor discovers a higher interest rate available on foreign securities and invests fund abroad. When the currency risk associated with the purchase of foreign securities is reduced by using a forward contract, this transaction is often referred to as "covered interest arbitrage."
To illustrate the interest arbitrage process, let us suppose that a British auto company I selling high-grade bonds with a promised annual yield of 12 percent. Comparable bonds in the United States offer a 10 percent annual return. While the bonds are of good quality and there is probably little default risk, there is currency risk in this transaction. The U.S. investor must purchase pounds in order to buy the British bonds. When the bonds earn interest or reach maturity, the issuing auto company will pay foreign and domestic investors in pounds sterling. Then the sterling must be converted into dollars to allow the U.S. investor to spend the earnings in the United States. If the spot price of sterling falls, the U.S. Investor‘s net yield from the bonds will be reduced.
Indeed, if the market value of sterling declines far enough, any profit from the bond purchase may be eliminated. Specifically, while the investor expects an interest spread of 2 percent a year over U.S. interest rates by purchasing British bonds, if the spot rate on pounds declines by 2 percent (on an annual basis), the interest gain will be exactly offset by the loss on trading pounds. Clearly, a series of forward contracts is needed to sell pounds at a guaranteed price as the bonds generate a stream of cash payments. In this case the investor will probably purchase sterling spot in order to buy the bonds and sell sterling forward to protect the expected income.