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Covered interest parity: A forecasting approach to estimate the neutral band

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  • Hernández, Juan R.

Abstract

This paper introduces a new approach to estimate the neutral band, where deviations from covered interest parity (CIP) are not considered profitable arbitrage opportunities. The approach fills a gap in the literature on international finance and is theoretically grounded. Using daily Pound Sterling-US Dollar data from 2000 to 2021, I illustrate that estimates based on the forecast distribution of CIP deviations with a time-varying variance component are superior to the mean-based estimates currently available. The results reveal that the estimated neutral band adapts to market dynamics, widening from 3 to 191 basis points as financial stress and volatility increase. The forecasting approach is further validated on G10 and emerging market currency pairs. Market participants can use these findings to set minimum profit targets in CIP trading, while policymakers can assess the liquidity of the foreign exchange market more effectively.

Suggested Citation

  • Hernández, Juan R., 2025. "Covered interest parity: A forecasting approach to estimate the neutral band," Economic Modelling, Elsevier, vol. 148(C).
    • Handle: RePEc:eee:ecmode:v:148:y:2025:i:c:s0264999325000719
    DOI: 10.1016/j.econmod.2025.107076
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    More about this item

    Keywords

    Covered interest parity; Carry trade; Stochastic volatility; Predictive distribution;
    All these keywords.

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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