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FRM Part I · FRM Exam Part I · Foreign Exchange Markets

Which statement best describes how relative PPP differs from covered interest parity?

Relative PPP ties expected currency changes to inflation differences and is only a tendency, since goods arbitrage is imperfect. Covered interest parity ties forward rates to interest rate differences and is enforced by riskless arbitrage using forward contracts.

  1. ARelative PPP links expected exchange rate changes to inflation differentials and is not enforced by arbitrage, while covered interest parity links forward rates to interest differentials and is enforced by arbitrageCorrect
  2. BBoth are enforced by riskless arbitrage
  3. CRelative PPP uses interest rates and covered interest parity uses inflation
  4. DRelative PPP holds exactly in the short run, covered interest parity holds only in the long run

Explanation

Covered interest parity can be enforced by riskless arbitrage using forwards. PPP relies on goods markets, with transport costs and nontraded goods, so deviations can persist for long periods.

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