Interest Rate Parity - Empirical Evidence

Empirical Evidence

Covered interest rate parity (CIRP) is found to hold when there is open capital mobility and limited capital controls, and this finding is confirmed for all currencies freely traded in the present-day. One such example is when the United Kingdom and Germany abolished capital controls between 1979 and 1981. Maurice Obstfeld and Alan Taylor calculated hypothetical profits as implied by the expression of a potential inequality in the CIRP equation (meaning a difference in returns on domestic versus foreign assets) during the 1960s and 1970s, which would have constituted arbitrage opportunities if not for the prevalence of capital controls. However, given financial liberalization and resulting capital mobility, arbitrage temporarily became possible until equilibrium was restored. Since the abolition of capital controls in the United Kingdom and Germany, potential arbitrage profits have been near zero. Factoring in transaction costs arising from fees and other regulations, arbitrage opportunities are fleeting or nonexistent when such costs exceed deviations from parity. While CIRP generally holds, it does not hold with precision due to the presence of transaction costs, political risks, tax implications for interest earnings versus gains from foreign exchange, and differences in the liquidity of domestic versus foreign assets. Researchers found evidence that significant deviations from CIRP during the onset of the global financial crisis in 2007 and 2008 were driven by concerns over risk posed by counter parties to banks and financial institutions in Europe and the US in the foreign exchange swap market. The European Central Bank's efforts to provide US dollar liquidity in the foreign exchange swap market, along with similar efforts by the Federal Reserve, had a moderating impact on CIRP deviations between the dollar and the euro. Such a scenario was found to be reminiscent of deviations from CIRP during the 1990s driven by struggling Japanese banks which looked toward foreign exchange swap markets to try and acquire dollars to bolster their creditworthiness.

When both covered and uncovered interest rate parity (UIRP) hold, such a condition sheds light on a noteworthy relationship between the forward and expected future spot exchange rates, as demonstrated below.

Dividing the equation for UIRP by the equation for CIRP yields the following equation:

which can be rewritten as:

This equation represents the unbiasedness hypothesis, which states that the forward exchange rate is an unbiased predictor of the future spot exchange rate. Given strong evidence that CIRP holds, the forward rate unbiasedness hypothesis can serve as a test to determine whether UIRP holds (in order for the forward rate and spot rate to be equal, both CIRP and UIRP conditions must hold). Evidence for the validity and accuracy of the unbiasedness hypothesis, particularly evidence for cointegration between the forward rate and future spot rate, is mixed as researchers have published numerous papers demonstrating both empirical support and empirical failure of the hypothesis.

UIRP is found to have some empirical support in tests for correlation between expected rates of currency depreciation and the forward premium or discount. Evidence suggests that whether UIRP holds depends on the currency examined, and deviations from UIRP have been found to be less substantial when examining longer time horizons. Some studies of monetary policy have offered explanations for why UIRP fails empirically. Researchers demonstrated that if a central bank manages interest rate spreads in strong response to the previous period's spreads, that interest rate spreads had negative coefficients in regression tests of UIRP. Another study which setup a model wherein the central bank's monetary policy responds to exogenous shocks, that the central bank's smoothing of interest rates can explain empirical failures of UIRP. A study of central bank interventions on the US dollar and Deutsche mark found only limited evidence of any substantial effect on deviations from UIRP. UIRP has been found to hold over very small spans of time (covering only a number of hours) with a high frequency of bilateral exchange rate data. Tests of UIRP for economies experiencing institutional regime changes, using monthly exchange rate data for the US dollar versus the Deutsche mark and the Spanish peseta versus the British pound, have found some evidence that UIRP held when US and German regime changes were volatile, and held between Spain and the United Kingdom particularly after Spain joined the European Union in 1986 and began liberalizing capital mobility.