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Covered interest parity and arbitrage paradox in emerging markets: Evidence from the Korean market

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  • Suh, Sangwon
  • Kim, Young Ju

Abstract

While emerging forward exchange markets (EMs) have been rapidly developed, market efficiency has rarely been examined for EMs. To properly test the market efficiency for EMs, we set up a simple model to account for EM-specific realistic features. Based on the new model, we develop a modified covered interest parity (CIP) condition, which features multiple neutral bands associated with both transaction costs and differential borrowing costs. In addition, we apply the notion of ‘arbitrage paradox’ to test market efficiency. In particular, we focus not only on the violation event of the (modified) CIP condition but also on the persistence of arbitrage opportunities. We then apply this methodology to the Korean forward exchange market and provide empirical results for the Korean market, which can also be useful for analyzing other EMs.

Suggested Citation

  • Suh, Sangwon & Kim, Young Ju, 2016. "Covered interest parity and arbitrage paradox in emerging markets: Evidence from the Korean market," Pacific-Basin Finance Journal, Elsevier, vol. 38(C), pages 161-176.
    • Handle: RePEc:eee:pacfin:v:38:y:2016:i:c:p:161-176
    DOI: 10.1016/j.pacfin.2016.04.003
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    2. Pippenger, John, 2018. "Forward Bias, Uncovered Interest Parity And Related Puzzles," University of California at Santa Barbara, Economics Working Paper Series qt1778z416, Department of Economics, UC Santa Barbara.
    3. Mehmet Altuntas, 2021. "The Interest Rate Parity in Fragile Five Countries: Evidence from Unit Root Tests with Breaks," Journal of Economic Policy Researches, Istanbul University, Faculty of Economics, vol. 8(2), pages 327-349, July.
    4. Pippenger, John, 2017. "Forward Bias, The Failure Of Uncovered Interest Parity And Related Puzzles," University of California at Santa Barbara, Economics Working Paper Series qt2ff194s2, Department of Economics, UC Santa Barbara.
    5. Bilson, Chris & Brailsford, Tim & Rajaguru, Gulasekaran, 2022. "Covered interest rate parity deviations in the Asia-Pacific," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 77(C).

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    More about this item

    Keywords

    Covered interest parity; Arbitrage paradox; Emerging markets; Market efficiency;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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