Due to ____, market forces should realign the relationship between the interest rate differential of two currencies and the forward premium (or discount) on the forward exchange rate between the two currencies.

Question

Quizplus · Accepted Answer

Covered interest arbitrage should lead to a realignment between the interest rate differential of two currencies and the forward premium (or discount) on the forward exchange rate between the two currencies. This is because when there is a discrepancy between the two, investors can borrow in one currency, convert it to another currency, invest it at a higher interest rate, and then hedge the resulting foreign exchange risk with a forward contract. If the forward premium (or discount) is too high (or too low) relative to the interest rate differential, investors will engage in covered interest arbitrage until the two are aligned.

Due to ____, Market Forces Should Realign the Relationship Between