If interest rate parity does not hold,
A) covered interest arbitrage opportunities will exist.
B) covered interest arbitrage opportunities will not exist.
C) arbitragers will be able to make risk-free profits.
D) covered interest arbitrage opportunities will exist, and arbitragers will be able to make risk-free profits.
E) covered interest arbitrage opportunities will not exist, and arbitragers will be able to make risk-free profits.

Question

Quizplus · Accepted Answer

Interest rate parity ensures that the return on investments in different currencies is equal once hedged against exchange rate risk. If it does not hold, it implies that there are discrepancies in interest rates across countries that are not offset by the forward exchange rate, allowing for covered interest arbitrage. This means arbitragers can exploit these differences for risk-free profits by borrowing in a currency with a lower interest rate, converting it to a currency with a higher interest rate, investing, and hedging against exchange rate risk.

If Interest Rate Parity Does Not Hold