Question

Suppose you observe that 90–day interest rate across the eurozone is 5%, while the interest rate in the U.S. over the same time period is 3%. Further, the spot rate and the 90–day forward rate on the euro are both $1.25.

You have $500,000 that you wish to use in order to engage in covered interest arbitrage.

Which of the following best describes covered interest arbitrage?

a)Using forward contracts to mitigate default risk, while attempting to capitalize on equal interest rates across countries

b)Using forward contracts to mitigate interest rate risk, while attempting to capitalize on equal interest rates across countries

c)Using forward contracts to mitigate default risk, while attempting to capitalize on higher interest rates in a particular country

d)Using forward contracts to mitigate exchange rate risk, while attempting to capitalize on higher interest rates in a particular country

Answer 1

The answer is d)Using forward contracts to mitigate exchange rate risk, while attempting to capitalize on higher interest rates in a particular country.

In a covered interest arbitrage, you borrow money in a particular country's currency which has lower interest rate and invest money in a particular country's currency which has higher interest rate. for future exchange rate risk, you enter in forward contract to fix the future exchange rate.

Options a, b and c are not correct because there is no equal interest rates across countries and default and interest risk. the forward contracts are for selling euros and not to mitigate default or interest risk.