In a covered interest arbitrage, what instrument commonly hedges exchange-rate risk?

In a covered interest arbitrage, a forward contract commonly hedges exchange-rate risk.

The strategy exploits an interest-rate difference between two countries while removing the uncertainty of a future currency conversion. An investor typically exchanges domestic currency for foreign currency at the spot rate, invests the foreign funds, and simultaneously agrees to reverse the exchange later through a forward contract.

The forward fixes the future exchange rate and therefore locks in the domestic-currency value of the foreign investment’s proceeds. This is what makes the strategy “covered”: the investor is protected against an adverse movement in the exchange rate during the investment period. Without that hedge, the transaction would be an uncovered interest strategy and could lose money if the foreign currency weakened.

The forward rate is linked to the spot rate and the two interest rates by covered interest parity. In frictionless markets, that relationship removes easy arbitrage gains. Real-world deviations can persist because of transaction costs, funding constraints, credit risk, capital regulations, and differences in market liquidity. A spot quote only states today’s exchange rate; it does not hedge a future exposure.