Asked by Myrick Kelly on Jul 29, 2024
Verified
If interest rate parity does not hold,
A) covered interest arbitrage opportunities will exist.
B) covered interest arbitrage opportunities will not exist.
C) arbitragers will be able to make risk-free profits.
D) covered interest arbitrage opportunities will exist, and arbitragers will be able to make risk-free profits.
E) covered interest arbitrage opportunities will not exist, and arbitragers will be able to make risk-free profits.
Interest Rate Parity
A theory stating that the difference in interest rates between two countries is equal to the expected change in exchange rates between those countries' currencies.
Covered Interest Arbitrage
An investment strategy that involves taking advantage of the interest rate differential between two countries while hedging against exchange rate risk.
Risk-Free Profits
Profits made through investment strategies that are supposed to incur no risk to the investor.
- Acquire knowledge on the mechanisms of covered interest arbitrage, understand its role in ensuring interest rate parity, and examine its influence on the pricing of currency futures.
Verified Answer
ZK
Zybrea KnightAug 02, 2024
Final Answer :
D
Explanation :
Interest rate parity ensures that the return on investments in different currencies is equal once hedged against exchange rate risk. If it does not hold, it implies that there are discrepancies in interest rates across countries that are not offset by the forward exchange rate, allowing for covered interest arbitrage. This means arbitragers can exploit these differences for risk-free profits by borrowing in a currency with a lower interest rate, converting it to a currency with a higher interest rate, investing, and hedging against exchange rate risk.
Learning Objectives
- Acquire knowledge on the mechanisms of covered interest arbitrage, understand its role in ensuring interest rate parity, and examine its influence on the pricing of currency futures.