Suppose that the annual interest rate is 5.0 percent in the United States and 3.5 percent in Germany, and that the spot exchange rate is $1.12/€ and the forward exchange rate, with one-year maturity, is $1.16/€. Assume that an arbitrager can borrow up to $1,000,000 or €892,857 (which is the equivalent of $1,000,000 at the spot exchange rate of $1.12/€).
-The above mentioned scenario:
A) is an example of covered interest arbitrage (CIA), and interest rate parity (IRP) holds.
B) is an example of covered interest arbitrage (CIA), and interest rate parity (IRP) does NOT hold.
C) is an example of Purchasing Power Parity (PPP), and hyperinflation.
D) none of these

Question

Quizplus · Accepted Answer

This is an example of covered interest arbitrage because an arbitrager can borrow in the currency with the lower interest rate (Germany) and invest in the currency with the higher interest rate (US) by exchanging € for $ at the spot rate and then investing in the US with a return of 5%. The arbitrager can then sell the investment after one year, convert the dollars back to euros using the forward rate, and repay the € loan with interest at 3.5%. However, interest rate parity (IRP) does NOT hold because the forward rate is higher than the expected future spot rate (which is $1.12*(1+5%) = $1.176), indicating that the market expects the dollar to appreciate against the euro, and this creates an opportunity for profit through covered interest arbitrage.

Suppose That the Annual Interest Rate Is 5