A capital outflow from New York to Frankfurt under covered interest arbitrage can take place if the interest differential in favor of Frankfurt is:

Question

Quizplus · Accepted Answer

In covered interest arbitrage, an investor can borrow currency in a low-interest rate country and invest it in a high-interest rate country to earn a profit. However, this strategy only works if the expected return from the investment is greater than the cost of borrowing, which includes both the interest rate differential and the forward discount or premium on the currency.

If the interest differential in favor of Frankfurt is smaller than the forward discount on the euro, then the expected return from the investment would be lower than the cost of borrowing, making the strategy unprofitable.

If the interest differential is equal to the forward discount on the euro, then the investor's expected return will just cover the cost of borrowing, resulting in no profit.

Therefore, the only scenario in which a capital outflow from New York to Frankfurt can occur under covered interest arbitrage is if the interest differential in favor of Frankfurt is larger than the forward discount on the euro. This would create a profitable opportunity for investors to borrow in New York and invest in Frankfurt, generating a capital outflow from the former to the latter.

A Capital Outflow from New York to Frankfurt Under Covered