Hello I need assistance answering these 2 multiple choice qu

Hello,

I need assistance answering these 2 multiple choice questions.

The following is a graphical representation of the interest rate parity (IRP) line: Forward discount (%) Forward premium (%) The dashed line is the IRP line. Which of the following is not true (assume that there are no market imperfections)? 0 a. Any point lying to the left of the IRP line represent covered interest arbitrage opportunities for home country investors. O b. Any point lying to the left of the IRP line represent covered interest arbitrage opportunities for foreign investors. C. Any point lying on the IRP line represent interest rate parity. d. Any point lying to the right of the IRP line represent covered interest arbitrage opportunities for home country investors

Solution

(1) Solution: Option A is untrue.
Reason: In the plot, it clearly shows that any point lying left to IRP line means forward rate is quoting at a discount compared to spot and viceversa.consider an example where a point lies to the left side of IRP. I.e., if spot=50INR/$ then forward=45INR/$. So a dollar invested now@10% interest per annum will earn 1.1$ after 1 year. hence 1.1$*45=49.5INR/$ which is less than spot price. hence it is not an arbitrage opportunity for home country investors.

(2)Solution: Option B: The process of borrowing in one currency and simultaneously investing in another currency with exchange risk hedged with the forward contract is referred as covered interest arbitrage.