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Answer: For currencies A (domestic) and B (foreign), CIP requires only the spot and forward exchange rates for A and B and the money market interest rate on A.
## Explanation Statement C is incorrect because Covered Interest Parity (CIP) requires interest rates for **both** currencies, not just one. The CIP formula is: \[F = S \times \frac{(1 + r_d)}{(1 + r_f)}\] Where: - F = Forward exchange rate - S = Spot exchange rate - r_d = Domestic interest rate - r_f = Foreign interest rate To verify CIP or engage in arbitrage, you need interest rates for both currencies A and B, not just currency A. **Why the other statements are correct:** - **A**: If CIP doesn't hold, arbitrage opportunities exist - **B**: CIP ensures consistency between FX-implied rates and money market rates - **D**: This correctly describes the relationship between forward-spot differential and interest rate differential
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Q-77. Which of the following statements regarding covered interest parity (CIP) is not correct?
A
If CIP does not hold, market participants could make arbitrage profits.
B
The principle of CIP holds that interest rates implied in foreign exchange markets should be consistent with spot short-term interest rates.
C
For currencies A (domestic) and B (foreign), CIP requires only the spot and forward exchange rates for A and B and the money market interest rate on A.
D
CIP states that the forward and spot exchange differential on two currencies should mimic the difference of money market interest rates on these currencies.
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