Due to ____, market forces should realign the relationship between the interest rate differential of two currencies and the forward premium (or discount) on the forward exchange rate between the two currencies. forward realignment arbitrage triangular arbitrage covered interest arbitrage locational arbitrage
Question
Due to ____, market forces should realign the relationship between the interest rate differential of two currencies and the forward premium (or discount) on the forward exchange rate between the two currencies. forward realignment arbitrage triangular arbitrage covered interest arbitrage locational arbitrage
Solution
The answer is "covered interest arbitrage".
Covered interest arbitrage is a strategy where an investor uses a forward contract to hedge against exchange rate risk. The strategy involves three steps:
- The investor borrows money in a country with a lower interest rate.
- Then, they convert the borrowed money into a foreign currency and invest in a foreign country with a higher interest rate.
- Finally, the investor hedges their foreign exchange risk with a forward contract.
If the relationship between the interest rate differential of two currencies and the forward premium (or discount) on the forward exchange rate between the two currencies is not aligned, an arbitrageur could potentially make a risk-free profit. This is because they could borrow in the currency with the lower interest rate, invest in the currency with the higher interest rate, and hedge the exchange rate risk with a forward contract.
Therefore, any misalignment should be corrected by market forces due to covered interest arbitrage.
Similar Questions
Due to ____, market forces should realign the cross exchange rate between two foreign currencies based on the spot exchange rates of the two currencies against the U.S. dollar forward realignment arbitrage triangular arbitrage covered interest arbitrage locational arbitrage
Due to ____, market forces should realign the spot rate of a currency among banks. forward realignment arbitrage triangular arbitrage covered interest arbitrage locational arbitrage
The situation in which the difference in interest rates between two currencies is equal to the expected change in the spot rate over the same time period is known as: Question 1 Answer a. the uncovered interest parity. b. the forward-spot reversal. c. the covered interest arbitrage. d. the covered interest parity.
Bank dealers in conversations among themselves use a shorthand notation to quote bid and ask forward prices in terms of forward points. This is convenient because forward points may change faster than spot and forward quotes.traders who are looking for violations of covered interest arbitrage are less interested in the actual spot and forward exchange rates but are interested in the premium or discount differential measured in forward points.both “forward points may remain constant for long periods of time, even if the spot rates change frequently” and “traders who are looking for violations of covered interest arbitrage are less interested in the actual spot and forward exchange rates, but are interested in the premium or discount differential measured
Suppose that the annual interest rate is 2.0 percent in the United States and 4 percent in Germany, that the spot exchange rate is $1.60/€ and that the forward exchange rate, with one-year maturity, is $1.50/€. Assume that an arbitrager can borrow up to $1,000,000 or €625,000. If an astute trader finds an arbitrage, what is the net cash flow in one year?
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