Answer to Question #303963 in Macroeconomics for Hyatt

Question

A trader collects the below information to devise his forex management strategy during

the next year:

Spot Rate of USD: INR 74.40

Interest rates in USA: 2.5%

Interest rates in India: 6.5%

a) What is Interest Rate Parity Theory? What will be the expected exchange rate in the above

case, if the interest rate parity theory is assumed to hold good. Also calculate the forward

premium or discount.

b) What is covered interest arbitrage? If there is a one-year forward contract available at

INR 75.60, is there a CIA possible, and if yes, write the steps to earn arbitrage profit (use

an equivalent amount of INR 1000000)

Answer 1

$IRP=S_{t, \frac{a}{b}}\frac{1+i_a}{1+i_b}$

$= S_{t, \frac{a}{b}}\frac{1+0.25}{1+0.65}$

$=76$ %

Covered interest arbitrage is an arbitrage trading strategy where the trader capitalizes on the interest rate differential between two countries by using a forward contract to cover exchange rate risk.