Explain why the absence of covered interest arbitrage possibilities can be characterized by two inequalities in the presence of bid–ask spreads in the foreign exchange and external currency markets

Question

What will be an ideal response?

Answer 1

Because there are bid-ask spreads in the foreign exchange market and in the external currency market, we do not convert from one currency to another at the same spot or forward exchange rates, and we do not borrow at the same rate at which we lend. The absence of covered interest arbitrage therefore is characterized by two inequalities. We cannot profit by borrowing the domestic currency (at the ask domestic interest rate), converting to the foreign currency (at the ask spot rate of domestic currency per unit of foreign currency), lending the foreign currency (at the foreign bid interest rate), and converting to the domestic currency in the forward market (at the bid forward rate of domestic currency per unit of foreign currency). Similarly, we cannot profit by borrowing the foreign currency (at the ask foreign interest rate), converting to domestic currency (at the bid spot rate of domestic currency per unit of foreign currency), lending the domestic currency (at the domestic bid interest rate), and converting to the foreign currency forward (at the ask forward rate of domestic currency per unit of foreign currency).