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

Which statement best describes the arbitrage logic that underpins covered interest parity?

Covered interest parity says that borrowing in one currency, converting at spot, investing abroad and hedging with a forward yields no riskless profit over the domestic rate. It is a no-arbitrage condition, unlike uncovered parity, which relies on expected future spot rates and carries exchange rate risk.

  1. ABorrowing in one currency, converting at spot, investing in the other currency and hedging the return with a forward contract should yield no riskless profit beyond the domestic rateCorrect
  2. BInvesting in the currency with the higher interest rate always earns an excess return because exchange rates follow a random walk
  3. CThe forward exchange rate equals the expected future spot rate, so unhedged positions earn the same as hedged ones
  4. DThe interest rate differential between two currencies must equal the difference in their countries' inflation rates

Explanation

CIP is a no-arbitrage relation: a fully hedged foreign investment must earn the same as the domestic investment. The option on expected spot describes uncovered interest parity, which involves exchange rate risk and is not a pure arbitrage. The inflation option describes a Fisher/PPP-type relation.

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