Question

According to the interest rate parity theory, any violation of the parity condition will lead to:

a)      stable equilibrium conditions

2. covered interest arbitrage
3. identical rates of return in dollars on domestic and foreign riskfree T-bills

Answer 1

As per Interest rate parity theorem, the returns after hedging in different currencies will be equal no matter the interest rates. In case of violation of interest rate parity theorem, the investors can capitalize on the difference between the interest rate between two countries by using the forward contracts which is basically the covered interest arbitrage.

Hence a. covered interest arbitrage is correct.

Stable equilibrium conditions and identical rate of returns happen when the interest rate parity theorem holds true. In case of violation, these conditions do not hold true.