Chartered Financial Analyst (CFA) Practice Exam Level 2

What is the purpose of Covered Interest Rate Parity?

1. To allow for arbitrage profits through currency hedging

2. To hedge against exchange rate risk using forward contracts

3. To predict currency movements over long periods

4. To enhance bond valuation strategies

The correct answer is: To hedge against exchange rate risk using forward contracts

The purpose of Covered Interest Rate Parity (CIRP) is fundamentally to ensure that arbitrage opportunities are eliminated when investing in different currencies while accounting for interest rates. When an investor hedges against exchange rate risk using forward contracts, they effectively lock in the future exchange rates based on the interest rate differential between two currencies. This means that as long as the interest rates between the two currencies are in line with the forward and spot rates, there shouldn't be any incentive for arbitrage. The concept is built on the idea that if covered interest rate parity holds, an investor should not be able to earn a risk-free profit by borrowing in one currency, converting it, investing it in another currency, and then converting it back at a forward rate. This relationship helps maintain equilibrium in the currency markets. Although hedging effectively reduces the risk of currency fluctuations, in the context of CIRP, the focus is on how these relationships create a no-arbitrage condition, aligning currency values and interest rates across borders. Therefore, using forward contracts is crucial in realizing CIRP, rather than unpredictable predictions of currency movements or strategies unrelated to interest rates and financial instruments.