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An empirical test of the interest rate parity: does it hold between U.S.A and selected emerging Asian economies?

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. The forward rate was predicted based on the following equation:

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

The two sample t-test was done for two samples, assuming equal variances for each pair. If the computed t was greater than the critical t then the null hypothesis was rejected, otherwise it would be concluded that interest rate parity holds between the U.S. and each of the emerging Asian economies.

LITERATURE REVIEW

Interest rates and exchange rates are sometimes influenced by political pressures. Liability dollarization and lobbying activity interact to influence exchange rate policy in emerging market economies. There is a reluctance to allow the currency to float freely because of political pressures from different interest groups, specifically the producing and financial sectors, although exchange rate movements could be beneficial from a social perspective. This assumes one period small open economic model where two groups of individuals have conflicting interest towards exchange rate policy. The first group is producers of tradable goods who seek loans in domestic currency to cover the cost of production, but get paid in foreign currency in trading those goods. They stand to gain from an ex-post depreciation of the domestic currency. The second group is the bankers, who are producers of an intermediary service. They obtain funds from the world market; therefore, their assets are in domestic currency, but liabilities are in foreign currency. Therefore they gain from an appreciation of the domestic currency. However, both parties dislike excessive volatility in the exchange market as it increases the cost to both parties. The excessive volatility increases the cost of gathering funds from abroad for the bankers and it causes them to charge a higher interest rate to producers. Both parties are organized and have lobbies with diverging objectives. They try to influence the government to have exchange rate policy to appreciate local currency while the lobbyists of the producers want exchange rate policies to depreciate the local currency (Ester, Massimo, Michele, 2008).

Fixed exchange rate regimes are considered temporary even though it can last up to a decade. Usually freely floating regimes last longer than pegged regimes, especially among developed countries. The main problem is how to exit a pegged exchange regime to a free floating exchange rate regime. One should exit a pegged exchange rate regime when economic conditions globally and domestically are favorable. There is a difference between orderly exit from pegged exchange rate regimes which is followed by better economic performance (Abi, Nedezhda, Chuda).

There is considerable literature on joint intervention in the foreign exchange market. Intervention provides credible information about future policy decisions. Such policy decision may relate to interest rates. The joint intervention in the foreign exchange market by both the Japanese and American central banks on 17 June 1998 was effective. However, the effectiveness of the joint intervention is not instantaneous and does not last very long. The fundamental determinant of exchange rates is not intervention but rather capital flow and economic performance. Therefore joint intervention has very little impact on exchange rate which is short lived. Capital flow can be influenced by interest rates which will influence exchange rate. Monetary authorities in any country cannot rely solely on intervention to stabilize exchange rates (Chen, Huang, 2008).

The modern approach to forward exchange rate determination suggests that the equilibrium forward exchange rate is determined by the actions of two groups, arbitrageurs and speculators. It was found that there is a systematic long run relationship between the current forward exchange rate, the parity forward exchange rate and one period ahead spot exchange rate. It is also concluded that speculation plays a very negligible role in determining forward exchange rate (Karfakis, Costas, 2008).

According to uncovered interest rate parity, it is predicted that currencies yielding a high return will depreciate; however, an increase in real interest rate will appreciate the currency. In the short run there may be deviation of the UIRP but it does hold in the long run. Empirical research has found that deviation from UIRP if fairly strong should not be ignored. There is arbitrage opportunity in the short run because in the long run UIRP holds (Geert, Yuhang, 2007).

The value of the Malaysian ringgit has been a controversial issue in the most recent times. The authorities decided in September 1998 to peg the ringgit to the U.S. dollar after a sharp decline of about 23 percent in real effective terms during the crisis of 1997 and 1998. The peg remained in effect until July 2005. During these seven years the current account balance increased significantly and was in continuous surplus, unusual for an emerging economy. The foreign reserve continued to increase since mid 2002, reflecting recurring intervention by the Malaysian central bank to prevent the appreciation of the ringgit. This prevented the ringgit from reaching an equilibrium exchange rate. The equilibrium exchange rate of the ringgit appreciated during the first half of the 1980s because of expansionary fiscal policy. There was fiscal contraction along with rise in international trade because of the government's commitment to an open trade regime which eventually resulted in the depreciation of the ringgit during the second half of the 1980s (Koske, 2008). In an analysis of East Asian interdependence in the face of global imbalances using a multinational macroeconometric model, it was found that a depreciation of the dollar and reduced U.S. demand have contrasted effects on East Asian economics. The U.S. deficit is important for China and other East Asian countries. The study compares between fixed versus more flexible exchange rate regimes in East Asia. It shows that depreciation of the dollar has more impact on Korea and slowdown of demand has more impact on China (Jaques, Yonghyup, Shophie, 2008).

It is widely accepted that forward exchange rates are not unbiased predictors of future spot exchange rates and therefore there is nonzero returns to forward speculation. It is believed that if forward speculation consists systematic risk, there should be nonzero return from speculation. The paper analyzes exante return on forward speculation and attempts to determine if it can be explained by a model of foreign exchange risk premium. According to uncovered interest rate parity hypothesis, the expected profit to forward speculation should be zero. There are significant ex-ante returns to forward speculation in five currencies in relation to the dollar and four currencies relative to the Deutche mark (Cumby, 1988).

According to uncovered interest rate parity it is argued that the presence of different interest rates in different countries can be explained by expected changes in exchange rates, although empirically this theory does not hold (Michael, Christensen; Granket, Froot; Mark, Wu). Therefore one could reasonably argue that there are other factors besides interest rates that influence the exchange rates. For the purpose of this study however, we concentrate only on those variables involved in interest rate parity theory, such as forward rates, spot rates, and domestic and foreign interest rates. However, sometimes spot exchange rates are influenced by policy behavior such as increasing or decreasing interest rates to stabilize exchange rates (Christenssen, 2000). The forward rate has often been referred to as a biased predictor of the future spot rate (Ballie, Bollerslev). Kevin Clinton emphasized transaction cost as being relevant in his study (Clinton, 1988). However, in most studies involving covered interest arbitrage the transaction cost is usually ignored.

In an efficient market forward exchange rate is the sum of the expected future spot rates plus the risk premium (Byers, Peel, 1991). McCullum argues that forward market for foreign exchange is inefficient, therefore the notion that forward rate is an unbiased estimator of forward spot rate is not valid (McCullum, 1993). However, in my study it is assumed that the market is efficient and forward rates are an unbiased estimate of the future spot rates.

Normally it is expected that currencies with high interest rates tend to appreciate against those with lower interest rates in the spot market (Flood, Rose, 1996). However, this is not true for the emerging markets in Asia.

Although several studies have rejected the interest rate parity theory, nevertheless the theory is used both by academicians and policy makers because there is no alternative theory. Mayfield and Murphy suggest that a time varying risk premium is responsible for the rejection of the interest rate parity theory (Mayfield, Murphy, 1992).

RESULTS

The results of the t-test are given in Table 1 as follows.

Based on the t-test and the computed t-value, we must accept the null hypothesis and conclude that interest rate parity does hold between the United States and the emerging Asian economies of Philippines, India, Singapore, Thailand, Korea, Pakistan and Malaysia.

Although we conclude that interest rate parity between the U.S. and emerging Asian economies holds in the long run, nevertheless, an intelligent investor may be able to identify certain time periods when there might be opportunity for covered interest arbitrage.

Let us say; for example, in the year 1997 the interest rate in the U.S.A. was 5.39 percent and the interest rate in Singapore was 3.41 percent. The spot rate was Singapore dollar = .7144 U.S. dollar and the forward rate was .5968 U.S. dollar per Singapore dollar. Let us put these numbers in our interest rate parity equation. We consider the U.S. as the domestic country.

(1.0539) = (1.0341) (.5968/.7144) therefore (1.0539) > .8639

Since the domestic side is greater, one should borrow in Singapore and deposit in U.S.A. to make an arbitrage profit.

Let us borrow S$1,000,000. Convert to U.S. $ at .7144 U.S. dollars per Singapore dollar, which will give $714,400. Invest in U.S. at 5.39 percent. 714,400(1.0539) = $752,906. Convert to Singapore dollar at forward rate of .5968 U.S. dollar per Singapore dollar. This will give Singapore dollar S$1,261,572. Since you borrowed S$1,000,000 at 3.41 percent, you will owe S$1,034,100.
Cash received from U.S. deposit     S$1,261,572
Amount owed on Singapore loan       S$1,034,100
Net arbitrage gain                    S$227,472


Similarly if one looks carefully, there may be such opportunities between the U.S.A. and other emerging Asian economies.

CONCLUSION

The empirical test of the Interest Rate Parity suggests that Interest Rate Parity holds between the United States and emerging economies of Asia like Singapore, Thailand, Korea, Philippines, Malaysia, India and Pakistan in the long run. However, an intelligent arbitrageur can find covered interest arbitrage opportunity during certain years as indicated above between the U.S.A. and Singapore. It may be mentioned here that Singapore is ideal for covered interest arbitrage because it has no currency control or restriction. It may be concluded that Interest Rate Parity holds in the long run between the U.S.A. and emerging economies of Asia, nevertheless there is always opportunity during certain periods for covered interest arbitrage.

REFERENCES

Atil, Wyplosz & Nadezhda (2008, July). How to exit from fixed exchange rate regime? International Journal of Finance and Economics, 13(3).

Baillie, R.T. & T. Bollerslev (2000). The forward premium anomaly is not as bad as you think. Journal of International Money & Finance, 19(4), 471-488.

Bekaert & Yuhang (2007, October). Uncovered interest rate parity and the term structure. Journal of International Money and Finance, 26(6).

Berk, J.M. & K.H.W. Knot (2001). Testing for long horizon UIP using PPP based exchange rate expectations. Journal of Banking and Finance, 25(2), 377-391.

Chen & Huang (2008, April). The effectiveness of joint intervention on the yen/U.S. dollar exchange rate. Applied Economics Letters, 15(5).

Christensen, M. (2000). Uncovered interest parity and policy behavior: New evidence. Economics Letters, 69 (1), 81-87.

Cumby, R. (1988). Is it risk? Explaining deviations from uncovered interest rate parity. Journal of Monetary Economics, 22(2), 279-292.

Clinton, K. (1988). Transactions cost and covered interest arbitrage: Theory and evidence. Journal of Political Economy, 96(2), 358-370.

Ester, Massimo & Michele (2008, May). Political pressures and exchange rate stability in emerging market economies. Journal of Applied Economics, II(I).

Eun & Resnick, (2001). International Financial Management, Irwin, McGraw-Hill.

Fama, E.F., (1984). Forward and spot exchange rates. Journal of Monetary Economics, 14(3), 319-338.

Frankel, J.A. & K.A. Froot, (1987). Exchange rate forecasting techniques, survey data, and implications for the foreign exchange market. NBER Working Paper No. 3470.

Frankel, J.A. & K.A. Froot, (1987). Using survey data to test standard propositions regarding exchange rate expectations. American Economic Review, 77(1), 133-153.

Huisman, Koedijk, Kool & Nissen (1997). Extreme support for uncovered interest parity. Journal of International Money and Finance, 17(1).

IMF (2001). International Financial Statistics, LIV.

IMF (2001). Annual Report on Exchange arrangements and exchange restrictions.

IMF (2008). International Financial Statistics Yearbook 2008.

Karfakis, Costas (2008, March). What determines the forward exchange rate of the Euro? Applied Financial Economics Letters, 4(2).

Koske, Isabel (2008, June). Assessing the equilibrium exchange rate of the Malaysian ringgit: A comparison of alternative approaches. Asian Economic Journal, 22(2).

Mark, N.C. & Y. Wu (1998). Rethinking deviations from uncovered interest parity: The role of covariance risk and noise. Economic Journal, 108(451), 1686-1707.

Mayfield, E.S. & R.G. Murphy (1992). Interest rate parity and the exchange risk premium: Evidence from panel data. Economics Letters, 40(3), 319-324.

Mazier, Jaques & YongHyup Oh (2008, February). Exchange rates, global imbalances and interdependence in East Asia. Journal of Asian Economics, 19(1).

McCullum, B.T. (1994). A reconsideration of the uncovered interest parity relationship. Journal of Monetary Economics, 33(1), 105-132.

Mohammed Ashraful Haque, Texas A&M University--Texarkana
Table 1

Country Pair         Critical T-value     Actual Value     Decision

U.S.-Philippines          2.0859              .8445         Accept
U.S.-India                2.0859             1.1486         Accept
U.S.-Singapore            2.0859             -.7165         Accept
U.S.-Thailand             2.0859              .4194         Accept
U.S.-Korea                2.0859              .6129         Accept
U.S.-Pakistan             2.0859              .3779         Accept
U.S.-Malaysia             2.0859             -.5429         Accept
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Author:Haque, Mohammed Ashraful
Publication:Journal of International Business Research
Geographic Code:1USA
Date:Jul 1, 2010
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