CFA Level IDerivativesHard
The current spot exchange rate is $1.20 per euro. The one-year risk-free rate is 5% in the United States and 3% in the eurozone. Using covered interest rate parity, what is the theoretical one-year forward exchange rate?
- A$1.1769 per euro
- B$1.2233 per euro
- C$1.2600 per euro
- D$1.2000 per euro
Show answer & explanationAnswer & explanation
Correct answer: B. $1.2233 per euro
Covered interest rate parity states F = S × (1+r_domestic)/(1+r_foreign) = 1.20 × (1.05/1.03) = 1.20 × 1.0194 = $1.2233 per euro. The currency with the higher interest rate (USD) trades at a forward discount relative to its own... here the euro trades at a forward premium since USD has the higher rate.
Why the other options are wrong
- A. This inverts the interest rate ratio, applying the foreign rate in the numerator instead.
- C. This overstates the adjustment by using an incorrect combination of rates.
- D. This assumes no interest rate differential, ignoring covered interest rate parity entirely.
Covered Interest Rate Parity
Covered interest rate parity states that the forward exchange rate must adjust for the interest rate differential between two currencies to prevent arbitrage.
- F = S × (1+r_domestic)/(1+r_foreign)
- Higher domestic rate implies forward premium on foreign currency
- Prevents riskless arbitrage between money markets and FX forwards
Memory trick: Higher rate currency's counterpart trades at a forward premium — quote domestic over foreign.