Which of the following is not true regarding covered interest arbitrage?
A) Covered interest arbitrage is a reason for observing interest rate parity (IRP).
B) If the forward rate is equal to the spot rate, conducting covered interest arbitrage will yield a return that is exactly equal to the interest rate in the foreign country.
C) When interest rate parity holds, covered interest arbitrage is not possible.
D) When interest rate disparity exists, covered interest arbitrage may not be profitable.
E) All of these are true.

Question

Quizplus · Accepted Answer

All the statements provided are true regarding covered interest arbitrage. Covered interest arbitrage is a strategy used by investors to take advantage of differences in interest rates between two countries while hedging against exchange rate risk, which is consistent with the reasons for observing interest rate parity (IRP). When the forward rate equals the spot rate, the return from covered interest arbitrage would indeed match the foreign interest rate, assuming no transaction costs or other market frictions. The existence of interest rate parity means that the potential for profit from covered interest arbitrage is eliminated because any differences in interest rates are offset by the forward exchange rate, making arbitrage unprofitable. Lastly, even when there is an interest rate disparity, it does not guarantee profitability due to potential costs, risks, or market conditions that could negate the arbitrage opportunity.

Which of the Following Is Not True Regarding Covered Interest