Nonlinear dynamics and covered interest rate parity

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 transactions cost 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 autoregressive/threshold ARCH model in which the dynamic behavior of deviations from covered interest parity differs outside the transactions cost band than inside them. We find that while the impulse response functions when inside the transactions cost band are nearly symmetric, those for the outside the bands are asymmetric--suggesting less persistence outside of the transactions cost band than inside the band.