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

Which of the following assumptions is NOT required for covered interest parity to hold as a no-arbitrage relationship?

Covered interest parity does not require that expected future spot rates equal the forward rate, because the exchange risk is hedged with the forward contract. That assumption belongs to uncovered interest parity. CIP needs only frictionless borrowing, lending, forward access and unconstrained balance sheets to keep arbitrage working.

  1. AInvestors can borrow and lend at the same risk-free rate in each currency
  2. BForward and spot markets are accessible with negligible transaction costs
  3. CInvestors' expectations of the future spot rate equal the forward rateCorrect
  4. DCapital can move freely without binding balance sheet constraints

Explanation

CIP relies on being able to lock in the forward rate, so expectations about future spot rates are irrelevant. That expectation condition belongs to uncovered parity. The other options (frictionless borrowing and lending, low costs, no balance sheet constraints) are conditions for arbitrage to enforce CIP.

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