Interest rate parity
[1] The fact that this condition does not always hold allows for potential opportunities to earn riskless profits from covered interest arbitrage.
Two assumptions central to interest rate parity are capital mobility and perfect substitutability of domestic and foreign assets.
Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets.
Investors then cannot earn arbitrage profits by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, due to gains or losses from exchanging back to their domestic currency at maturity.
[1] Economists have found empirical evidence that covered interest rate parity generally holds, though not with precision due to the effects of various risks, costs, taxation, and ultimate differences in liquidity.
This relationship can be employed to test whether uncovered interest rate parity holds, for which economists have found mixed results.
Maurice Obstfeld and Alan Taylor calculated hypothetical profits as implied by the expression of a potential inequality in the CIRP equation (meaning a difference in returns on domestic versus foreign assets) during the 1960s and 1970s, which would have constituted arbitrage opportunities if not for the prevalence of capital controls.
[1][5] While CIRP generally holds, it does not hold with precision due to the presence of transaction costs, political risks, tax implications for interest earnings versus gains from foreign exchange, and differences in the liquidity of domestic versus foreign assets.
Such a scenario was found to be reminiscent of deviations from CIRP during the 1990s driven by struggling Japanese banks which looked toward foreign exchange swap markets to try and acquire dollars to bolster their creditworthiness.
[9] Other explanations question common assumptions underlying the CIRP condition, such as the choice of discount factors.
Evidence for the validity and accuracy of the unbiasedness hypothesis, particularly evidence for cointegration between the forward rate and future spot rate, is mixed as researchers have published numerous papers demonstrating both empirical support and empirical failure of the hypothesis.
[10] UIRP is found to have some empirical support in tests for correlation between expected rates of currency depreciation and the forward premium or discount.
[13] A study of central bank interventions on the US dollar and Deutsche mark found only limited evidence of any substantial effect on deviations from UIRP.
[14] UIRP has been found to hold over very small spans of time (covering only a number of hours) with a high frequency of bilateral exchange rate data.
[15] Tests of UIRP for economies experiencing institutional regime changes, using monthly exchange rate data for the US dollar versus the Deutsche mark and the Spanish peseta versus the British pound, have found some evidence that UIRP held when US and German regime changes were volatile, and held between Spain and the United Kingdom particularly after Spain joined the European Union in 1986 and began liberalizing capital mobility.
This condition is known as real interest rate parity (RIRP) and is related to the international Fisher effect.
where If the above conditions hold, then they can be combined and rearranged as the following: RIRP rests on several assumptions, including efficient markets, no country risk premia, and zero change in the expected real exchange rate.
There exists strong evidence that RIRP holds tightly among emerging markets in Asia and also Japan.
Such variation in the half-lives of deviations may be reflective of differences in the degree of financial integration among the country groups analyzed.
