Explain how banks and individuals can use “covered interest arbitrage” to protect themselves when they make international financial investments.

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Covered interest arbitrage is a strategy used by banks and individuals to protect themselves from exchange rate risk when making international investments. It involves borrowing money in one currency, converting the funds into another currency, investing the funds for a specific period of time, and then repaying the loan in the original currency. By doing this, investors are able to take advantage of any potential differences between the two currencies’ interest rates while mitigating any risk associated with changes in exchange rates.

The basic principle behind covered interest arbitrage is that investors can lock in an expected return on their investment even if exchange rates fluctuate during the investment period. This is because they have already exchanged their starting amount of money into a different currency at a predetermined rate. As long as they are able to pay back their loan after its term ends using the same amount of starting money (plus or minus accrued interest), they will enjoy whatever benefit comes with having invested at higher returns than would have been available in their home country’s markets.

For example, let’s say an investor has US$100 but believes that British Pound Sterling offers better investment opportunities than US Dollars do at present prices. The investor could use covered interest arbitrage by exchanging his US$100 for £80 and then investing it for 1 year at 5% annual return in GBP terms (4% higher than what he’d get back home). After 12 months, he would repay his initial loan plus 4%, giving him back £83 ($108). In other words, even though exchange rates may have changed over that period of time, he still gets 4% more due to taking advantage of higher yields abroad—all without taking on additional foreign-exchange risks thanks to pre-hedging his exposure through exchanging currencies before investing abroad.