Final answer:
Covered interest arbitrage moves the market toward equilibrium by narrowing the differential between the spot and forward currency rates, as investors engage in transactions that augment the demand for forward contracts and adjust forward prices to reflect differing interest rates. The correct answer is option a.
Step-by-step explanation:
The question pertains to the concept of covered interest arbitrage in the foreign exchange market. Covered interest arbitrage is a trading strategy in which an investor uses a forward contract to hedge against exchange rate risk. The investor borrows in one currency, converts the funds into another currency, and invests in interest-bearing instruments. In anticipation of future exchange rate changes, the same investor sells the invested amount in the forward market.
When an investor undertakes covered interest arbitrage, they purchase a currency on the spot market and sell it in the forward market if the forward rate is attractive. This action serves to narrow the differential between the spot and forward rates, hence pushing the market toward equilibrium. The rationale behind this is that as more investors engage in this strategy, the demand for the forward contracts of the currency will increase, which eventually adjusts the forward price to reflect the difference in interest rates between the two countries.
Therefore, the correct answer to the question "Covered interest arbitrage moves the market ________ equilibrium because ________" is Option A: toward; purchasing a currency on the spot market and selling in the forward market narrows the differential between the two.