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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 5.00% and the one-year EUR interest rate is 3.00%. Spot EUR/USD is 1.1000 USD per EUR. Under covered interest parity with no frictions, what is the one-year forward EUR/USD rate (USD per EUR), to four decimals?

The forward rate is 1.1214 USD per EUR. Under covered interest parity the forward equals spot times the ratio of gross USD to EUR interest rates, 1.1000 x 1.05/1.03, so the higher-yielding USD trades at a forward discount.

  1. A1.1214Correct
  2. B1.1000
  3. C1.0791
  4. D1.1220

Explanation

CIP: F = S x (1+r_USD)/(1+r_EUR) = 1.1000 x 1.05/1.03 = 1.1214. Check: 1.1000 x 1.019417 = 1.12136. Option 1.0791 inverts the ratio; 1.1220 adds the 2% differential to spot (1.1000 x 1.02) instead of using the compounded ratio.

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