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

The 3-month USD rate is 5.00% (annualised, simple, act/360 approximated as 0.25 year) and the 3-month EUR rate is 3.00%. Spot EUR/USD is 1.1000 USD per EUR. Under CIP, what is the 3-month forward rate (USD per EUR), approximately?

The CIP forward rate is about 1.1055 USD per EUR. It is spot 1.1000 multiplied by 1.0125 over 1.0075, the USD growth factor divided by the EUR growth factor. The lower-yielding euro trades at a forward premium to offset the higher dollar interest rate.

  1. A1.1055Correct
  2. B1.0945
  3. C1.1000
  4. D1.1110

Explanation

F = S × (1+0.05×0.25)/(1+0.03×0.25) = 1.1000 × 1.0125/1.0075 = 1.1000 × 1.004963 = 1.10546, about 1.1055. The 1.0945 option inverts the premium sign (EUR is the lower-rate currency so it trades at a forward premium). 1.1110 uses an annual rather than quarterly differential.

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