IDEAS home Printed from https://ideas.repec.org/p/bis/biswps/1206.html
   My bibliography  Save this paper

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

Author

Listed:
  • Juan R. Hernández

Abstract

The neutral band is the interval where deviations from covered interest parity (CIP) are not considered profitable arbitrage opportunities. After the great financial crisis, deviations from CIP are no longer short-lived, exposing some limitations of the previous approaches to estimate the neutral band. In this paper, I argue that the one-step-ahead forecast distribution of deviations from CIP, with a time-varying variance component, provides an intuitive estimate of the neutral band. I use data for the Pound Sterling-US Dollar cross from 2000 to 2021, and find that a stochastic volatility model outperforms several alternative models in terms of fit and forecasting capability. The model estimates neutral band that are intuitive and consistent with market dynamics, widening during financial stress periods and consistent with no arbitrage. The results are maintained when I use data from the Mexican Peso-US Dollar cross.

Suggested Citation

  • Juan R. Hernández, 2024. "Covered interest parity: a forecasting approach to estimate the neutral band," BIS Working Papers 1206, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:1206
    as

    Download full text from publisher

    File URL: https://www.bis.org/publ/work1206.pdf
    File Function: Full PDF document
    Download Restriction: no
    File URL: https://www.bis.org/publ/work1206.htm
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Gino Cenedese & Pasquale Della Corte & Tianyu Wang, 2021. "Currency Mispricing and Dealer Balance Sheets," Journal of Finance, American Finance Association, vol. 76(6), pages 2763-2803, December.
    2. Fratzscher, Marcel & Gloede, Oliver & Menkhoff, Lukas & Sarno, Lucio & Stöhr, Tobias, 2019. "When Is Foreign Exchange Intervention Effective? Evidence from 33 Countries," EconStor Open Access Articles and Book Chapters, ZBW - Leibniz Information Centre for Economics, vol. 0(1), pages 132-156.
    3. Geweke, John & Amisano, Gianni, 2010. "Comparing and evaluating Bayesian predictive distributions of asset returns," International Journal of Forecasting, Elsevier, vol. 26(2), pages 216-230, April.
    4. Graham Elliott & Allan Timmermann, 2016. "Economic Forecasting," Economics Books, Princeton University Press, edition 1, number 10740.
    5. Larry G. Epstein & Stanley E. Zin, 2013. "Substitution, risk aversion and the temporal behavior of consumption and asset returns: A theoretical framework," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 12, pages 207-239, World Scientific Publishing Co. Pte. Ltd..
    6. Sangjoon Kim & Neil Shephard & Siddhartha Chib, 1998. "Stochastic Volatility: Likelihood Inference and Comparison with ARCH Models," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 65(3), pages 361-393.
    7. Bollerslev, Tim, 1986. "Generalized autoregressive conditional heteroskedasticity," Journal of Econometrics, Elsevier, vol. 31(3), pages 307-327, April.
    8. Graham Elliott & Allan Timmermann, 2016. "Forecasting in Economics and Finance," Annual Review of Economics, Annual Reviews, vol. 8(1), pages 81-110, October.
    9. Ted Juhl & William Miles & Marc D. Weidenmier, 2006. "Covered Interest Arbitrage: Then versus Now," Economica, London School of Economics and Political Science, vol. 73(290), pages 341-352, May.
    10. Branson, William H, 1969. "The Minimum Covered Interest Differential Needed for International Arbitrage Activity," Journal of Political Economy, University of Chicago Press, vol. 77(6), pages 1028-1035, Nov./Dec..
    11. Wenxin Du & Alexander Tepper & Adrien Verdelhan, 2018. "Deviations from Covered Interest Rate Parity," Journal of Finance, American Finance Association, vol. 73(3), pages 915-957, June.
    12. Koopman, Siem Jan & Shephard, Neil (ed.), 2015. "Unobserved Components and Time Series Econometrics," OUP Catalogue, Oxford University Press, number 9780199683666.
    13. Deardorff, Alan V, 1979. "One-Way Arbitrage and Its Implications for the Foreign Exchange Markets," Journal of Political Economy, University of Chicago Press, vol. 87(2), pages 351-364, April.
    14. Peel, David A & Taylor, Mark P, 2002. "Covered Interest Rate Arbitrage in the Interwar Period and the Keynes-Einzig Conjecture," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(1), pages 51-75, February.
    15. Frenkel, Jacob A & Levich, Richard M, 1977. "Transaction Costs and Interest Arbitrage: Tranquil versus Turbulent Periods," Journal of Political Economy, University of Chicago Press, vol. 85(6), pages 1209-1226, December.
    16. Hernández, Juan R., 2014. "Peso-Dollar Forward Market Analysis: Explaining Arbitrage Opportunities during the Financial Crisis," MPRA Paper 100653, University Library of Munich, Germany.
    17. Frenkel, Jacob A & Levich, Richard M, 1975. "Covered Interest Arbitrage: Unexploited Profits?," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 325-338, April.
    18. Stefan Avdjiev & Wenxin Du & Cathérine Koch & Hyun Song Shin, 2019. "The Dollar, Bank Leverage, and Deviations from Covered Interest Parity," American Economic Review: Insights, American Economic Association, vol. 1(2), pages 193-208, September.
    19. Hernández Juan R., 2014. "Peso-Dollar Forward Market Analysis: Explaining Arbitrage Opportunities during the Financial Crisis," Working Papers 2014-09, Banco de México.
    20. Campbell, John Y, 1993. "Intertemporal Asset Pricing without Consumption Data," American Economic Review, American Economic Association, vol. 83(3), pages 487-512, June.
    21. Zhiguo He & Arvind Krishnamurthy, 2018. "Intermediary Asset Pricing and the Financial Crisis," Annual Review of Financial Economics, Annual Reviews, vol. 10(1), pages 173-197, November.
    22. Frenkel, Jacob A, 1973. "Elasticities and the Interest Parity Theory," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 741-747, May-June.
    23. Darjus Hosszejni & Gregor Kastner, 2019. "Modeling Univariate and Multivariate Stochastic Volatility in R with stochvol and factorstochvol," Papers 1906.12123, arXiv.org, revised Feb 2021.
    24. Wenxin Du & Jesse Schreger, 2016. "Local Currency Sovereign Risk," Journal of Finance, American Finance Association, vol. 71(3), pages 1027-1070, June.
    25. Clinton, Kevin, 1988. "Transactions Costs and Covered Interest Arbitrage: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 358-370, April.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Hernández Juan R., 2020. "Covered Interest Parity: A Stochastic Volatility Approach to Estimate the Neutral Band," Working Papers 2020-02, Banco de México.
    2. 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).
    3. Akram, Q. Farooq & Rime, Dagfinn & Sarno, Lucio, 2008. "Arbitrage in the foreign exchange market: Turning on the microscope," Journal of International Economics, Elsevier, vol. 76(2), pages 237-253, December.
    4. Ibhagui, Oyakhilome, 2020. "Covered interest parity deviations in standard monetary models," Journal of Economics and Business, Elsevier, vol. 111(C).
    5. 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.
    6. Gino Cenedese & Pasquale Della Corte & Tianyu Wang, 2021. "Currency Mispricing and Dealer Balance Sheets," Journal of Finance, American Finance Association, vol. 76(6), pages 2763-2803, December.
    7. Liao, Gordon Y., 2020. "Credit migration and covered interest rate parity," Journal of Financial Economics, Elsevier, vol. 138(2), pages 504-525.
    8. Patrick Augustin & Mikhail Chernov & Lukas Schmid & Dongho Song, 2024. "The Term Structure of Covered Interest Rate Parity Violations," Journal of Finance, American Finance Association, vol. 79(3), pages 2077-2114, June.
    9. Chernov, Mikhail & Augustin, Patrick & Schmid, Lukas & Song, Dongho, 2020. "The term structure of CIP violations," CEPR Discussion Papers 14774, C.E.P.R. Discussion Papers.
    10. Christopher E.S. WARBURTON, 2018. "Covered Interest Parity And Frictions In Currency And Money Markets: Analysis Of British Pound And Dollar For The Period 1999-2006," Applied Econometrics and International Development, Euro-American Association of Economic Development, vol. 18(1), pages 55-72.
    11. Cerutti, Eugenio M. & Obstfeld, Maurice & Zhou, Haonan, 2021. "Covered interest parity deviations: Macrofinancial determinants," Journal of International Economics, Elsevier, vol. 130(C).
    12. McBrady, Matthew R. & Schill, Michael J., 2007. "Foreign currency-denominated borrowing in the absence of operating incentives," Journal of Financial Economics, Elsevier, vol. 86(1), pages 145-177, October.
    13. Hyeyoon Jung, 2021. "Real Consequences of Shocks to Intermediaries Supplying Corporate Hedging Instruments," Staff Reports 989, Federal Reserve Bank of New York.
    14. Gong, Di & Jiang, Tao & Wu, Weixing, 2018. "A foreign currency effect in the syndicated loan market of emerging economies," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 52(C), pages 211-226.
    15. Eugenio Cerutti & Haonan Zhou, 2024. "Uncovering CIP Deviations in Emerging Markets: Distinctions, Determinants, and Disconnect," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 72(1), pages 196-252, March.
    16. Ted Juhl & William Miles & Marc D. Weidenmier, 2004. "Covered Interest Arbitrage: Then vs. Now," NBER Working Papers 10961, National Bureau of Economic Research, Inc.
    17. Blenman, Lloyd P. & Chen, Jianguo, 2001. "Non-reversed trade and equilibrium in forward exchange markets," The Quarterly Review of Economics and Finance, Elsevier, vol. 41(2), pages 259-277.
    18. Pasricha, Gurnain Kaur, 2006. "Survey of Literature on Covered and Uncovered Interest Parities," MPRA Paper 22737, University Library of Munich, Germany.
    19. Ibhagui, Oyakhilome, 2018. "The Monetary Model of CIP Deviations," MPRA Paper 89641, University Library of Munich, Germany.
    20. Fong, Wai-Ming & Valente, Giorgio & Fung, Joseph K.W., 2010. "Covered interest arbitrage profits: The role of liquidity and credit risk," Journal of Banking & Finance, Elsevier, vol. 34(5), pages 1098-1107, May.

    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

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bis:biswps:1206. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Martin Fessler (email available below). General contact details of provider: https://edirc.repec.org/data/bisssch.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.