## 22 Questions

Which concept is closely related to the failure of uncovered interest parity to hold?

Forward premium puzzle

What does uncovered interest parity state regarding the forward discount and the ex post change in the spot rate?

They should be in opposite directions

What is the error term in the equation that relates the spot rate, forward rate, and expectation of the spot rate?

Expectational error

What does covered interest rate parity maintain regarding domestic and foreign money market investments?

They have the same return

Which one of the following accurately describes Covered Interest Parity (CIP)?

CIP states that the forward premium of a foreign currency should be equal to the interest rate differential between a domestic asset and a substitutable foreign asset.

Which one of the following accurately describes Covered Interest Arbitrage?

Covered interest arbitrage is the transfer of liquid funds from one monetary center to another to take advantage of higher rates of return or interest, while covering the transaction with a forward currency hedge.

Suppose the 3-month T-bill rate in the U. S. is 12%, higher than the 3-month T-bill rate of 8% in Canada. If the spot exchange rate is 1.00CAD/USD at present, and the 3-month forward exchange rate is 0.99CAD/USD at present, what is the expected return from covered interest arbitrage in 3 months?

4%

What is CIP based on?

The assumption that the forward market is used to cover against exchange risk

What is UIP based on?

The assumption that transactions are conducted only in the current market

Why is it important to study UIP's potential validity/failure?

To ensure the effectiveness of interest rate policy to stabilize an exchange rate

What are the results of empirical UIP studies?

UIP is always tested in a form of equality between realized change in spot exchange rate and interest rate differential

What is the forward premium puzzle closely related to?

The failure of uncovered interest parity to hold

What does uncovered interest parity state regarding the forward discount and the ex post change in the spot rate?

The forward discount should be an unbiased predictor of the ex post change in the spot rate

What is the unbiasedness hypothesis?

There is no systematic difference between the forward rate and the expected future spot rate

What do regression estimates find regarding the regression coefficient in the equation relating the spot rate, forward rate, and expectation of the spot rate?

The regression coefficient is often not statistically significantly far from unity

Which one of the following accurately describes Covered Interest Parity (CIP)?

CIP states that the forward premium of a foreign currency should be equal to the interest rate differential between a domestic asset and a substitutable foreign asset.

What is Covered Interest Arbitrage?

Covered interest arbitrage is the transfer of liquid funds from one monetary center to another to take advantage of higher rates of return or interest, while covering the transaction with a forward currency hedge.

Suppose the 3-month T-bill rate in the U. S. is 12%, higher than the 3-month T-bill rate of 8% in Canada. If the spot exchange rate is 1.00CAD/USD at present, and the 3-month forward exchange rate is 0.99CAD/USD at present, what is the expected return from covered interest arbitrage in 3 months?

4%

What is the relationship between Covered Interest Parity (CIP) and the forward market?

CIP is based on the assumption that the forward market is used to cover against exchange risk

What is the main difference between Covered Interest Parity (CIP) and Uncovered Interest Parity (UIP)?

CIP assumes transactions are conducted in both current and forward markets, while UIP assumes transactions are conducted only in the current market

Why is it important to study the potential validity/failure of Uncovered Interest Parity (UIP)?

All of the above are reasons to study the potential validity/failure of UIP

What are the possible explanations for deviations from Covered Interest Parity (CIP)?

Transaction costs, possible capital controls, and difference in tax rates on interest income and foreign exchange losses/gains in different countries

Test your knowledge on Covered and Uncovered Interest Parities (CIP) with this quiz. Learn about the no-arbitrage condition and how it relates to interest rate differentials and financial assets in different currencies.

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