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The relationship between spot and forward exchange rates and domestic and foreign interest rates is examined with transactions costs in all markets. Market participants choose the least-cost method of exchanging currencies in these markets, thus engaging in one-way arbitrage if that is preferable to a direct transaction. One-way arbitrage consists of using one exchange market and the two securities markets to replace a direct transaction in the other exchange market. It is shown that one-way arbitrage should prevent rates from ever departing enough from interest parity for conventional covered interest arbitrage to break even.
Alan V. Deardorff (Sun,) studied this question.