Interest rate parity is a theory that suggests the difference in interest rates between two countries will be equal to the difference between the forward exchange rate and the spot exchange rate. This condition helps to eliminate covered interest arbitrage opportunities, where an investor seeks to exploit differences in interest rates between countries while hedging against exchange rate risk.

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Interest Rate Parity

Question 27

Multiple Choice

Interest rate parity

A) eliminates exchange rate fluctuations.
B) exists when spot rates are equal for multiple countries.
C) exists when the spot rate is equal to the forward rate.
D) means that the nominal risk-free rate of return must be the same across countries.
E) eliminates covered interest arbitrage opportunities.

Correct Answer: