Question

Describe two examples of situations from practice when the interest rate parity, or covered interest arbitrage led to poor results from faulty execution or naive application.

Answer 1

Interest rate Parity refers to a concept In which differential between the interest rate of the two countries is equal to the differential calculated by using the between the Forward exchange rate and Spot exchange rate.

The Covered Interest rate arbitrage can be defined as a strategy that is used to limit the exposure of the foreign echange exposure where in an investor capitalizes on the interest rate differential between the two countries using a cover of forward contract.

The interest rate parity or covered interest rate arbitrage may sometime lead to poor results because of faulty execution or naive application because sometimes the rate of exchange may be wrongly calculated. Sometimes there may be naive results because of the wrong interest rates differential.

Two examples where these strategies may lead to an inappropriate result are when the interest rates are wrong, and when the cover for arbitrage is taken at an abrnormal rate or calculated wrongly. If the interest rate is taken to be more in one country as compared to other. it will lead to larger interest rate differential which will lead to higher exchange rate resulting in tremendous increase in the trade and exchange. If the importing country does this mistake it will have ti bear huge losses.