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Chapter 7

Q. 7.ST.3

Using the information in the previous question, does interest rate parity exist? Explain.


Verified Solution

No. The forward rate discount on the pound does not perfectly offset the interest rate differential. In fact, the discount is 2.5 percent, which is larger than the interest rate differential. U.S. investors do worse when attempting covered interest arbitrage than when investing their funds in the United States because the interest rate advantage on the British investment is more than offset by the forward discount.
Further clarification may be helpful here. While the U.S. investors could not benefit from covered interest arbitrage, British investors could capitalize on covered interest arbitrage. While British investors would earn 1 percent interest less on the U.S. investment, they would be purchasing pounds forward at a discount of 2.5 percent at the end of the investment period. When interest rate parity does not exist, investors from only one of the two countries of concern could benefit from using covered interest arbitrage.