________ holds because of the possibility of covered interest arbitrage.

Question

Quizplus · Accepted Answer

Interest rate parity holds because of the possibility of covered interest arbitrage. Covered interest arbitrage occurs when an investor borrows in a low-interest-rate currency, converts those funds into a higher interest rate currency, and invests in a financial instrument in that currency with a maturity equal to the loan's term. The investor covers the exchange rate risk by simultaneously entering into a forward exchange contract to sell the currency received in the investment at the end of the investment horizon and use the proceeds to repay the loan. If interest rate parity does not hold, an opportunity for arbitrage profit exists, as the investor can obtain loans at lower interest rates than what they can invest in a higher-rate currency. The demand for the higher-rate currency would increase and appreciates it, reducing the attractiveness of the investment, while the supply of the low-rate currency would increase, depreciating it, and making the loan more expensive, eliminating the arbitrage opportunity.

________ Holds Because of the Possibility of Covered Interest Arbitrage