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Nonlinear dynamics and covered interest rate parity

Author

Listed:
  • Mark E. Wohar

    () (Distinguished Lucas Professor, Department of Economics,University of Nebraska at Omaha, CBA-512K, Omaha, NE 68182, USA)

  • Nathan S. Balke

    () (Department of Economics, Southern Methodist University, Dallas, TX 75275, USA and Research Department, Federal Reserve Bank of Dallas)

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.

Suggested Citation

  • Mark E. Wohar & Nathan S. Balke, 1998. "Nonlinear dynamics and covered interest rate parity," Empirical Economics, Springer, vol. 23(4), pages 535-559.
  • Handle: RePEc:spr:empeco:v:23:y:1998:i:4:p:535-559
    Note: received: April 1996/final version received: June 1997
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    Keywords

    Covered interest parity · impulse response · threshold autoregression;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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