When Interest Rate Parity (IRP)does not hold:
A) there is a high degree of inflation.
B) the financial markets are in equilibrium.
C) there are opportunities for covered interest arbitrage.
D) there are no opportunities for arbitrage.

Question

Quizplus · Accepted Answer

When IRP does not hold, there are opportunities for covered interest arbitrage. This means that investors can profit by borrowing in a currency with low-interest rates, converting it to a currency with higher interest rates, and then investing in a high-interest rate-bearing instrument. This process continues until the interest rates in both currencies equalize, and the arbitrage opportunity disappears. Therefore, the correct answer is C, and it implies that the financial markets are not in equilibrium when IRP is not holding. Choices A and B are incorrect because high inflation or market equilibrium does not determine the validity of IRP. Choice D is incorrect because, as mentioned earlier, there are opportunities for arbitrage.

When Interest Rate Parity (IRP)does Not Hold