Assume the U.S. interest rate is 2% higher than the Swiss rate, and the forward rate of the Swiss franc has a 4% premium. Given this information:
A) Swiss investors who attempt covered interest arbitrage earn the same rate of return as if they invested in Switzerland.
B) U.S. investors who attempt covered interest arbitrage earn a higher rate of return than if they invested in the U.S.
C) A and B
D) none of the above

Question

Quizplus · Accepted Answer

Since the U.S. interest rate is 2% higher than the Swiss rate, U.S. investors who attempt covered interest arbitrage would borrow in the U.S. at 2% higher rate and invest in Switzerland earning the Swiss interest rate. Now, since the forward rate of the Swiss franc has a 4% premium, the investor would sell the Swiss franc forward at a price 4% higher than its spot price at the maturity of the investment. The overall return will be the Swiss interest rate + forward premium - U.S. borrowing rate. Hence, U.S. investors who attempt covered interest arbitrage would earn a higher rate of return than if they invested in the U.S.