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COVERED INTEREST RATE PARITY.
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Examines empirical evidence to test whether theory held in period 1980-1998. Appendix with 5 Tables of data used in testing.... More...
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Paper Abstract:
Examines empirical evidence to test whether theory held in period 1980-1998. Appendix with 5 Tables of data used in testing.

Paper Introduction:
Covered Interest Rate Parity Report objective The objective of this report is to examine the theory of covered interest rate parity. Empirical evidence will then be analyzed to test whether the theory held over the eighteen year period, 1980 to 1998. Finally, the data used in empirical testing is presented in the appendix. Covered interest rate parity in theory The theory of covered interest rate parity states that the prices from risk free assets with identical maturity should be equated across countries, after translation into a common currency. (Univers

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Thus, taking intoaccount imperfect markets, the theory of covered interest rate parity doesappear to have some validity. As can be seen from Figure 2, there is a measurable difference betweenthe actual expected spot rate and present forward rate, but this differenceis relatively constant. Thiscondition is illustrated in Figure 1, where Covered Interest RateDifferential is charted over the time period examined. In addition descriptive statisticsfor the variables e, F, fp, ius, and ic are found in Table 2.Analysis As can be seen from the data, the covered interest parity conditiondid not hold at zero for the period studied. 8, and was low in the .5range. The results ofthese calculations are reprinted in Table 3. Covered Interest Rate ParityReport objective The objective of this report is to examine the theory of coveredinterest rate parity. Thus, once the differential for a particularcurrency is discovered, the expected future spot rate can serve as anunbiased approximate indicator of the present future rate. The uncovered interest rate differential was alsocalculated using the formula 1 x depus - (e x depc)(1/et_1). The Foreign Exchange Market. Available: http://spot.colorado.edu/~boileau/inbu/esm6.html.**All data gathered from Economagic.com. Alldata was collected from Economagic.com and can be found in Table 3. Again, the theory states onlythat the expected spot rate will approximate the present future rate. Empirical evidence will then be analyzed to testwhether the theory held over the eighteen year period, 198 to 1998.Finally, the data used in empirical testing is presented in the appendix.Covered interest rate parity in theory The theory of covered interest rate parity states that the pricesfrom risk free assets with identical maturity should be equated acrosscountries, after translation into a common currency. University of Colorado. Empirical evidence will then be analyzed to testwhether the theory held over the eighteen year period, 198 to 1998.Finally, the data used in empirical testing is presented in the appendix.Uncovered interest rate parity in theory The theory behind uncovered interest rate parity is thatforeign exchange markets are so efficient that the expected future spotexchange rate for a particular currency will, on average, equal the presentforward exchange rate. The forward premium was then calculated as an annual percentage usingthe formula fp=1+(i/4), where i = interest rate. The covered interest ratedifferential was also calculated using the formula (1xfp)-(Ex)(fp*)(1/Exf),where Ex=exchange rate and Exf=forward exchange rate. (University ofColorado, 2 , p.2) In other words, a risk free asset should cost thesame dollar amount whether purchased in $US or some other currency.Empirical analysis of covered interest rate parityThe data To test whether the theory of covered interest rate parity holds inreal markets, quarterly data was collected for the period 198 to 1998.Among the variables for which data was collected were the spot and forwardexchange rates for $US to $Canadian. This result is theoretically due to the fact thatinformation is quickly reflected in both the spot and forward exchangemarkets, that transaction costs are low or nonexistent, and thatinstruments denominated in different currencies are perfect substitutes forone another. However, the covered interestrate differential varied only by approximately . Available: http://www.economagic.com.-----------------------[pic][pic][pic][pic][pic][pic] Thiscondition is illustrated in Figure 2, where Uncovered Interest RateDifferential is charted over the time period examined. In addition, descriptivestatistics for the variables e, et_1, dep, ius, and ic are found in Table4.Analysis As can be seen from the data, the uncovered interest parity conditiondid generally hold for the period studied. The expected future exchange rate was then calculated using theformula dep = et_1-(et+et1=et2)/3 where t = current time period, tN = timeperiod N. Under the uncovered interest rate parity theory then, the purchase offoreign currency will generate essentially the same return whether made inthe spot or forward markets.Empirical analysis of uncovered interest rate parityThe data To test whether the theory of uncovered interest rate parity holds inreal markets, quarterly data was collected for the period 198 to 1998.Among the variables for which data was collected were the foreign exchangerates for $US to $Canadian. The foreignexchange market studied here is operating efficiently, if not with perfectefficiency.Appendix**Source: see References **Source: see References References 1. The results of thesecalculations are reprinted in Table 1. The failure of the theory is due greatly to the imperfect markets ofthe empirical world, but the results do show only a nominal difference inthe price of risk-free assets purchased in US or Canadian dollars. Uncovered Interest Rate ParityReport Objective The objective of this report is to examine the theory of uncoveredinterest rate parity. In addition, data on the Federal Funds Ratewas collected to represent domestic interest rates, and the Government ofCanada Marketable Bonds rate was used to represent foreign interest. Expected depreciation was then calculated using the formula(e/et_1)- (1+(1+(i/4))). (2 ). All data was collected from Economagic.com and can be found inTable 1. (University of Colorado, 2 , p.7). In addition, data on the FederalFunds Rate was collected to represent domestic interest rates, and theGovernment of Canada Marketable Bonds rate was used to represent foreigninterest.

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