An Empirical Test of the Interest Rate Parity: Does It Hold between U.S.A and Selected Emerging Asian Economies?

By Haque, Mohammed Ashraful | Journal of International Business Research, July 2010 | Go to article overview
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An Empirical Test of the Interest Rate Parity: Does It Hold between U.S.A and Selected Emerging Asian Economies?


Haque, Mohammed Ashraful, Journal of International Business Research


INTRODUCTION

The theory of Interest Rate Parity (IRP) holds that one cannot make arbitrage profits due to different interest rates in different countries. Any gain made because of interest rate differentials will be wiped out due to adjustment in the exchange rate at the end of the investment time horizon. Let us assume that the three month interest rate in the U.S.A. is 11 percent and the same three month interest rate in the U.K. is 7 percent. This would indicate that investors in the U.K. will transfer their funds to the United States to take advantage of the higher interest rates and to earn a higher return. However, the theory of interest rate parity holds that such arbitrage opportunity is not possible because after three months the U.S. dollar is expected to depreciate by approximately 4 percent. Therefore, the British investor will not be any better off at the end of three months because the 4 percent higher return in the U.S. will be wiped out when the dollar declines by 4 percent at the end of three months when the British investor converts the dollar for British pounds. This is an exchange rate risk. Exchange rate risk can be covered by selling the expected dollar value to be received after a three month investment period in the forward market. Therefore to gain from a covered interest arbitrage, a British investor must simultaneously buy dollars in the spot market and sell dollars in the forward market. This will increase the value of the dollar in the spot market and depreciate the value of the dollar in the forward market until equilibrium is reached and wipes out any arbitrage profit. Therefore, whether the investor invests in the U.K. or U.S.A., they should get the same return. This study does an empirical test to see if interest rate parity holds between the U.S.A. and emerging economies of Asia like Malaysia, Singapore, Thailand, Korea, India, Pakistan and Philippines.

PURPOSE AND METHODOLOGY

There is an abundance of research on interest rate parity, uncovered interest parity and covered interest parity. Very few deal with empirical tests. This study does an empirical test of the interest rate parity between the United States and selected emerging Asian economies of Malaysia, Korea, Singapore, Pakistan, India, Thailand and Philippines, and explores opportunity for covered interest arbitrage. Data were collected on all these countries from 1996 to 2007 on deposit rates and exchange rates, both spot and forward. For the purpose of this study transaction costs were ignored and it is assumed that forward rates are the best predictors of the future spot rates. For interest rate parity to hold, the following equation must hold.

(1+Di) = (1+Fi)(Forward rate/spot rate)

where

[D.sub.i] = Domestic interest rate

[F.sub.i] = Foreign interest rate

The spot rate and forward rate must be a direct quote that is unit of domestic currency per unit of foreign currency. If the above equation does not hold then we would conclude that one can gain from covered interest arbitrage. The left side of the equation represents the domestic and right side represents a foreign country. Whichever side of the equation is greater; one can make arbitrage profit by investing in that side and borrowing from the opposite side. Therefore the hypotheses being tested are as follows:

Null: Interest rate parity holds between U.S.A. and selected emerging Asian economies

Alt: Interest rate parity does not hold between U.S.A. and selected emerging Asian economies

Each one of the emerging Asian countries is paired with the United States, with the United States as the domestic country. The above equation was used to predict the forward rate that would hold the interest rate parity. If the predicted forward rate is equal to the actual forward rate, then we would accept the null hypothesis; otherwise we will reject the null hypothesis. The United States was paired with each emerging Asian country and the forward rate was predicted and compared with the actual forward rate.

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