If covered interest arbitrage opportunities exist,
A)interest rate parity does not hold.
B)interest rate parity holds.
C)arbitragers will be able to make risk-free profits.
D)interest rate parity does not hold, and arbitragers will be able to make risk-free profits.

Question

Quizplus · Accepted Answer

Covered interest arbitrage involves borrowing money in a currency with a low interest rate, exchanging it into a currency with a higher interest rate, and investing it in a financial instrument that will provide a higher return. If this can be done at a profit, it implies that interest rate parity does not hold, as according to interest rate parity, the return on any investment should be equalized across different currencies. However, covered interest arbitrage also implies that arbitragers can make risk-free profits, as they can hedge their currency exposure using a forward contract, eliminating any potential currency risk. Hence, covered interest arbitrage opportunities not only suggest the violation of interest rate parity but also provide a way for investors to earn a risk-free profit.

If Covered Interest Arbitrage Opportunities Exist