Question

Suppose you observe that 90–day interest rate across the eurozone is 6%, 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 $1.60.

You have $600,000 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 higher interest rates in a particular country

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

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

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

Please Explain.

Answer 1

Answer:

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

Reason :

Under covered interest arbitrage, funds are borrowed from the country with lower interest rate.

The same are converted into the other currency (of the country with higher interest rate) at the current spot exchange rate and invested in that country (with the higher interest rate).

Hence, this is an attempt to capitalize on the higher interest rates in a particular country.

Now, after the investment period is over, the invested funds are converted back to the original currency of borrowing at the forward contract rate that was fixed when forward contract was entered. Entering the forward contract helped in mitigating the currency exchange rate risk, because even if the invested currency depreciates during the investment period, it will not reduce our investment value because our forward rate was fixed.

Hence, the interest rate differential is exploited to capitalize on higher interest rate of a particular country, and the forward contract is used to mitigate exchange rate risk.