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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 economic logic of covered interest parity?

Covered interest parity says the forward premium or discount exactly offsets the interest rate gap between two currencies, so a fully hedged foreign investment earns the same return as a domestic investment. It is a no-arbitrage relationship, unlike uncovered parity, which relies on expected spot rates.

  1. AExpected future spot rates must equal forward rates, so currency risk is always rewarded
  2. BThe forward premium or discount offsets the interest rate differential, so a hedged foreign investment earns the same return as a domestic oneCorrect
  3. CInterest rates in two currencies must be equal after adjusting for inflation differentials
  4. DSpot exchange rates must remain constant when interest rates differ across countries

Explanation

CIP is a no-arbitrage condition: borrowing in one currency, converting at spot, investing, and selling the proceeds forward should yield no riskless profit. The forward premium/discount therefore offsets the interest differential. Option about expected spot describes uncovered parity, which involves risk.

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