CIA Covered Interest Flowchart
Interactive CFA drill

Covered interest arbitrage decision map

Click Through the Arbitrage Path

This site turns the covered interest arbitrage formula into an interactive flowchart. Choose a scenario, step through the cash flows, and watch the correct arbitrage path light up from borrowing to forward cover.

The flow uses the same convention as the formula page: \(S_{f/d}\) and \(F_{f/d}\) mean foreign currency per domestic currency.

Open flow lab Practice decisions
Choose the market condition, then step through the trade.
CHECK Compare F_mkt to F* F* = S(1+i_f)/(1+i_d) LOW 1 Borrow domestic d fund lower-return leg SPOT Sell d, buy f receive S_{f/d} units f LOW 2 Invest foreign f grow at 1+i_f COVER Buy d forward use f to repay d loan HIGH 1 Borrow foreign f fund lower-return leg SPOT Buy domestic d pay S_{f/d} units f HIGH 2 Invest domestic d grow at 1+i_d COVER Sell d forward receive f to repay loan PARITY No covered arbitrage domestic return equals covered foreign return

Formula Behind the Flowchart

The flowchart is just a visual version of covered interest parity. If the covered foreign path and the domestic path do not end at the same value, borrow the cheaper path and invest in the richer path.

No-arbitrage equality

\[(1+i_d)=\frac{S_{f/d}(1+i_f)}{F_{f/d}}\]

The right side is the domestic-currency return from converting into foreign currency, investing abroad, and locking the future conversion with a forward contract.

Forward parity rate

\[F_{f/d}^{*}=S_{f/d}\frac{1+i_f}{1+i_d}\]

Compare this fair forward with the market forward. \(F_{mkt}F^*\) points to the borrow-foreign path.

Three Decision States

CFA questions usually hide the answer in quote direction, bid/ask rates, or timing. The flowchart keeps the core decision separate before you add those complications.

\(F_{mkt}

Forward too low

Borrow domestic, buy foreign spot, invest foreign, and buy domestic forward. This locks in enough domestic currency to repay the domestic loan and keep a spread.

\(F_{mkt}=F^*\)

No arbitrage

The domestic money-market return equals the covered foreign return. Different interest rates alone do not prove arbitrage.

\(F_{mkt}>F^*\)

Forward too high

Borrow foreign, buy domestic spot, invest domestic, and sell domestic forward. The overpriced forward provides the excess foreign currency.

Flowchart Checkpoints

Use these short questions to test whether the direction of the arrows is clear. The point is speed: compute parity, compare, then name the flow.

Checkpoint 1

\(S_{USD/EUR}=1.1000\), \(i_{USD}=5\%\), \(i_{EUR}=3\%\), and \(F_{mkt}=1.1100\). What is the trade?

Correct: B. \(F^*=1.1000(1.05/1.03)=1.12136\). Since \(1.1100<1.12136\), borrow domestic EUR, invest foreign USD, and buy EUR forward.

Checkpoint 2

If the market forward is above the parity forward, which flowchart side should light up?

Correct: A. \(F_{mkt}>F^*\) means domestic currency is overpriced forward. Own domestic currency and sell it forward.

Checkpoint 3

What does the word "covered" mean in covered interest arbitrage?

Correct: C. The forward contract fixes the maturity exchange rate, so the trade is not exposed to uncertain future spot rates.

Checkpoint 4

In bid/ask problems, which rates should a trader use?

Correct: B. Transaction costs make the trade harder. CFA questions expect the executable side of every quote.