The interest rate differential that results from covered arbitrage between two rates denominated in different currencies. More specifically, the covered arbitrage differential (CAD) for currency X and currency Y, is calculated as follows:
CAD = (1 + RX) – (F/S) (1 + RY)
Where: RX and RY are the interest rates (e.g., T-bill rates) in country X and country Y, respectively. F and S are, respectively, the forward rate and spot rate for currency Y. The terms (1 + Rx) and (1 + RY) denote the principal plus interest for T-bill rate in country X and country Y.
The covered arbitrage differential may be positive or negative. If positive, an investor should sell T-bills of country Y, buy currency of country X (spot) with the proceeds denominated in currency Y, buy T-bill of country X, and sell currency X forward (buy currency Y forward). The resulted arbitrage is known as a round-trip arbitrage.
