CFA Level I · CFA Level I Exam · Capital Flows and the FX Market
Covered interest rate parity is enforced mainly by which of the following market forces?
Covered interest rate parity is enforced by arbitrage using forward contracts. When the forward rate departs from the level implied by spot and interest rates, traders can lock in a riskless profit by borrowing, converting, investing and hedging, and their trades push the forward rate back to parity.
- AArbitrage using forward contractsCorrect
- BCentral bank intervention in spot markets
- CDifferences in consumer price baskets
Explanation
Covered interest rate parity links the spot rate, the forward rate and the interest rate differential. If it is violated, traders can earn a riskless profit by borrowing in one currency, converting at spot, investing, and locking in the forward rate. This arbitrage drives the forward rate back to its parity value. Price baskets relate to purchasing power parity, not covered interest parity.
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