Assume the U.S. interest rate is 2% higher than the Swiss rate, and the forward rate of the Swiss franc has a 4% premium. Given this information:
A) Swiss investors who attempt covered interest arbitrage earn the same rate of return as if they invested in Switzerland.
B) U.S. investors who attempt covered interest arbitrage earn a higher rate of return than if they invested in the U.S.
C) A and B
D) none of the above

Question

Quizplus · Accepted Answer

The 4% premium in the forward rate of the Swiss franc indicates that the market expects the Swiss franc to appreciate against the U.S. dollar over time. Therefore, a U.S. investor who borrows in dollars, converts to Swiss francs, invests in Switzerland, and then converts the proceeds back to dollars at the forward rate can earn a higher rate of return than if they invested in the U.S. On the other hand, Swiss investors attempting covered interest arbitrage would not earn a higher rate of return than investing in Switzerland, as their returns would be reduced by the 2% higher U.S. interest rate.