Abstract
This paper examines the dynamics of deviations from covered interest parity using daily data on the UK/US spot, forward exchange rates and interest rates over the period January 1974 to September 1993. Like other studies we find a substantial number of instances during the sample in which the covered interest parity condition exceeds the transaction costs band, implying arbitrage profit opportunities. While most of these implied profit opportunities are relatively small, there is also evidence of some very large deviations from covered interest parity in the sample. In order to examine the persistence of these deviations, we estimated a threshold autoregression in which the dynamics behavior of deviations from covered interest parity is different outside the transaction costs band than inside them. We find that while the impulse response functions when inside the transaction costs band are nearly symmetric, those for the outside the bands are asymmetric-suggesting less persistence outside of the transaction costs band than inside the band.
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The authors would like to thank Jeanette Diamond, Michael O'Hara, Baldev Raj, and two anonymous referees for helpful suggestions on an earlier draft. The views expressed herein are solely those of the authors and should not be construed to be those of the Federal Reserve Bank of Dallas or the Federal Reserve System.
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Balke, N.S., Wohar, M.E. Nonlinear dynamics and covered interest rate parity. Empirical Economics 23, 535–559 (1998). https://doi.org/10.1007/BF01205993
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DOI: https://doi.org/10.1007/BF01205993