Covered interest parity: The untestable hypothesis

ABSTRACT

Although post Keynesian economists advocate the realistic bankers’ view of the forward exchange rate, neoclassical economists formulate (CIP) as a testable hypothesis. In reality, CIP represents a formula used by bankers to calculate the forward rates they quote to their customers. This article provides arguments for the post Keynesian view of the forward exchange rate and suggests that CIP is not a theory, that it is a microeconomic relation, and that it is a hedging rather than an arbitrage condition. An empirical illustration shows that deviations from CIP are observed whenever published data are used, but these deviations disappear when transaction data are used instead. It is concluded that CIP is an untestable hypothesis.

KEYWORDS:

• Cambist view of the forward rate
• covered interest parity
• measurement errors

JEL CLASSIFICATIONS:

• F31
• C12

Notes

¹Exactly the same definition (word-for-word) had been used earlier by Taylor (1987).

²One can only wonder what has happened to the basic finance principle that “there is no such thing as a free lunch”. Riskless arbitrage profit is a free lunch that is available to anyone.

³Aggarwal and Zong (2008) wonder why the forward-spot relation “remains a theoretical and empirical puzzle” whereas Aggarwal, Lucey, and Mohanty (2009) refer to “an important puzzle in international finance”, which is “the failure of the forward exchange rate to be a rational forecast of the future spot rate.” These propositions are incredibly naïve.

⁴See http://thismatter.com/money/forex/fx-forwards.htm.

⁵See http://www.microrate.com/media/docs/investment/V-Guide-to-FX-Fowards.pdf.

⁶See https://www.westpac.com.au/docs/pdf/pb/non-deliverable-forward-transact.pdf.

⁷See http://www.canadianforex.ca/our-services/forward-contracts.

⁸At least in the case of purchasing power parity, the law of one price is not as an exact relation as CIP, in which case aggregation is more legitimate.

⁹The Bloomberg database provides bid and offer interest rates as well as bid and offer spot and forward rates. The forward rate is expressed in terms of points, where each point is 100th of a cent. The outright forward rate is obtained by adding (in the case of a premium) or subtracting (in the case of a discount) to or from the spot rate. For example, if the spot rate between the Australian and U.S. dollar (in bid and offer) is 0.8899–0.8910 and the forward spread in points is 52–52, this means that the forward rate is 0.8951–0.8962. A positive spread in this case implies that the Australian dollar is selling at a forward premium, which is why the forward rate is higher than the spot rate.

¹⁰Transaction rates are specific to each transaction as negotiated between a customer and a bank. If Bloomberg advertises a certain forward rate on a particular date, this does not mean that any banker will be willing to deal on the basis of that rate. On any day, transaction rates vary and differ from one bank to another. Published data may be daily averages or closing rates taken from one particular source. The only forward rate on which a bank is willing to do business is the rate at allows the bank to hedge its position, which is calculated from covered interest parity (Equations 8 and 9). This is the point argued by Taylor (1987) and Committeri, Rossi, and Santorelli (1993), who conducted a valid test of CPI on the basis of transaction data.

¹¹The forward rates derived from CIP as a hedging condition are consistent with the no-arbitrage condition.

Additional information

Notes on contributors

Imad Moosa

Imad Moosa, School of Economics, Finance and Marketing, Royal Melbourne Institute of Technology, Melbourne, Australia.