Arbitrage in Interest Parity Quiz: No-Arbitrage Condition

Arbitrage enforces interest parity by ensuring that any deviation from the parity condition creates a profit opportunity. Traders immediately exploit this by borrowing in the cheap currency, investing in the expensive one, and using forward contracts if necessary. This activity adjusts demand, supply, and prices until the profit disappears and the parity condition is restored.

The answer is True. In covered interest arbitrage, the investor uses a forward contract to lock in the future exchange rate at the time the transaction begins. This eliminates the currency risk associated with converting back to the domestic currency at maturity. With both the investment return and the exchange rate fixed, the profit from any parity deviation can be calculated with certainty before any funds are committed.

If the pound trades at no forward premium or discount, the UK interest rate of 6 percent offers a 3 percent advantage over the US. An investor can borrow dollars, convert to pounds at the spot rate, invest in UK bonds, and simultaneously buy dollars forward to lock in the conversion back. This generates a risk-free profit of approximately 3 percent, which is a covered interest arbitrage opportunity.

All four steps are required to complete a covered interest arbitrage transaction. Borrowing in the low-rate currency provides the funds, converting at the spot rate moves them to the high-rate environment, investing earns the higher return, and the forward contract eliminates currency risk on the return conversion. Together they form the complete no-risk profit cycle that exploits parity deviations.

The answer is True. As traders execute covered interest arbitrage, they increase demand for the high-rate currency in the spot market and increase supply in the forward market. This pushes the spot rate up and the forward rate down, adjusting the forward premium or discount until it exactly offsets the interest rate differential. At that point, parity is restored and no further arbitrage profit is available.

Transaction costs include bid-ask spreads, borrowing costs above the risk-free rate, and fees associated with setting up the forward contract. If these costs exceed the profit available from exploiting a small parity deviation, the arbitrage becomes unprofitable and the deviation can persist. This is why small deviations from covered interest parity are commonly observed without triggering immediate arbitrage.

Uncovered interest arbitrage involves borrowing in a low-rate currency and investing in a high-rate currency without using a forward contract to hedge the return conversion. The investor is exposed to whatever the future spot rate turns out to be. If the high-rate currency depreciates as uncovered interest parity predicts, the profit is erased, but if it does not depreciate, the investor earns both the interest differential and a currency gain.

The answer is False. In well-functioning foreign exchange markets, arbitrage opportunities tend to disappear quickly because competitive traders actively search for and exploit any mispricing. The act of arbitrage itself closes the gap by adjusting spot rates, forward rates, and borrowing costs. While brief windows may open, persistent arbitrage profits are rare in liquid, efficient markets with freely flowing capital.

Covered interest arbitrage increases spot demand for the high-rate currency, pushing its spot rate up. It simultaneously increases forward supply of the high-rate currency, pulling its forward rate down. These adjustments widen the forward discount until it matches the interest differential and parity is restored. Domestic interest rates are set by monetary policy, not arbitrage activity, so option D is incorrect.

Triangular arbitrage involves comparing the exchange rates of three currencies and exploiting any inconsistency in their cross-rate pricing. While it is distinct from interest parity arbitrage, both share the core principle that competitive traders will exploit any pricing deviation in financial markets until prices adjust and the profit opportunity is eliminated, enforcing consistency across rates.

When covered interest parity holds perfectly, the forward exchange rate is set to exactly offset the interest rate differential. Any extra return from investing abroad is cancelled by the cost of converting back through the forward contract. The net result is a return equal to the domestic risk-free rate, leaving zero profit above what the investor would have earned by staying at home.

The answer is False. Capital controls restrict the free movement of funds across borders, which is essential for arbitrage to work. Without the ability to move capital freely, traders cannot borrow in one currency and invest in another to exploit parity deviations. Capital controls therefore weaken the arbitrage mechanism and allow deviations from covered interest parity to persist longer than they would in an open financial system.

Arbitrage faces real-world limits that prevent perfect enforcement of interest parity. Transaction costs make small deviations unprofitable. Capital controls block the cross-border flows needed for arbitrage. Counterparty and credit risk in forward contracts raise the effective cost of hedging. Same-currency countries share an exchange rate and do not face cross-currency parity conditions, making option D false.

A 0.5 percent covered return above the domestic rate that exceeds all transaction costs represents a genuine, risk-free profit opportunity. A rational trader will immediately execute covered interest arbitrage by borrowing at the domestic rate, converting to the foreign currency, investing at the higher foreign rate, and locking in the return conversion with a forward contract to capture the available profit.

Covered interest arbitrage produces a known, risk-free profit because the forward contract eliminates all exchange rate uncertainty. The return can be calculated precisely before any funds are committed. This certainty makes it far easier to identify and execute profitably. Uncovered arbitrage involves uncertain future spot rates, which makes the expected profit less reliable and introduces risk that discourages some participants.