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CFA Level IEconomicsHard

The current spot exchange rate is USD/EUR = 1.1000 (1 EUR = 1.10 USD). The 1-year interest rate is 5% in the United States and 3% in the Eurozone. Using covered interest rate parity, what is the approximate 1-year forward USD/EUR rate?

  1. A1.1429
  2. B1.0791
  3. C1.1214
  4. D1.1000
Show answer & explanation

Correct answer: C. 1.1214

Covered interest rate parity: F = S × (1 + i_USD)/(1 + i_EUR) = 1.10 × (1.05/1.03) = 1.10 × 1.0194 = 1.1214. The higher-interest-rate currency (USD) trades at a forward discount relative to EUR, so more USD is needed per EUR forward.

Why the other options are wrong

  • A. Overstates the forward rate beyond the CIP calculation.
  • B. Inverts the interest rate ratio incorrectly.
  • D. Ignores the interest rate differential entirely.

Covered Interest Rate Parity (CIP)

A no-arbitrage condition stating that the forward exchange rate reflects the interest rate differential between two currencies.

  • F = S × (1+i_domestic)/(1+i_foreign)
  • Higher interest rate currency trades at a forward discount
  • Prevents riskless arbitrage between money markets and FX forwards

Memory trick: High-rate currency loses value forward — 'high yield, low future price.'

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