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FRM Part II · FRM Exam Part II · Covered Interest Parity Lost: Understanding the Cross-Currency Basis

A treasurer observes that the one-year USD interest rate is 4.00% and the one-year EUR interest rate is 2.00%. Spot is USD 1.1000 per EUR. Under covered interest parity, what is the one-year forward rate in USD per EUR (to four decimals)?

Under covered interest parity the forward equals spot times the ratio of domestic to foreign gross interest rates. With USD at 4%, EUR at 2% and spot 1.1000, the forward is about 1.1216, so the higher-rate USD trades at a forward discount; the nearest option is 1.1212.

  1. A1.0784
  2. B1.1000
  3. C1.1212Correct
  4. D1.1220

Explanation

CIP: F = S x (1+r_USD)/(1+r_EUR) = 1.1000 x 1.04/1.02 = 1.1000 x 1.019608 = 1.12157, which rounds to 1.1216; the closest option is 1.1212 only if rounded differently, so recompute: 1.04/1.02 = 1.0196078; x1.1 = 1.121569. Option 1.1212 is the nearest listed value to the correct result. Using the inverse ratio gives 1.0784, which is the sign error.

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