Exchange Rate Economics: Theories and Evidence

Introduction 17
Frenkel and Levich (1975,1977) represent one of the first tests of CIP based on
calculation of the CD and they demonstrate,using Treasury Bills yields,that
there are many non-zero values of the calculated CD for both UK–US and
US–Canada combinations,but that 80% of these non-zero observations can
be explained by the various transaction costs associated with covered interest
arbitrage. Aliber (1973),however,has argued that Tbills are not well suited
for the calculation of CIP because they potentially suffer from both sovereign
and political risk. Since Euro-denominated bonds do not suffer from such risks
they are viewed as a better candidate for the calculation of CIP and when
they are used by Frenkel and Levich they report few non-zero values of CD.
Taylor (1989) has criticised CIP-based tests which use equation (1.13) or the CD
to test CIP because they do not use simultaneous quotes which investors would
actually have been working with. When Taylor uses high quality matched data
he finds that there are no deviations from CIP. This finding is consistent with the
so-called Cambist or Bankers view of covered interest parity which suggests that
commercial banks simply price forward rates off the interest differential (given the
spot rate). Under this view covered interest rate parity is essentially an identity.
1.7 Open and closed parityconditions
In the earlier analysis,we have argued that it is the uncertainty about the future
course of exchange rates that forces arbitrageurs to enter into forward contracts.
But if,in contrast,arbitrageurs have complete certainty about the future path of
exchange rates,or in the case of uncertainty,arbitrageurs are risk neutral (i.e. they
are only concerned with the expected return of their investment and not the risk),
what difference would this make to equation (1.11)? Under such circumstances the
forward exchange rate in (1.11) may be replaced by the natural logarithm of the
expected exchange rate, st+k e ,and we obtain:
i t − i ∗ t
= s e t+k − s t,(1.14)
or in terms of its rational expectations counterpart
i t − i ∗ t = E t s t+k − s t ,(1.14 ′ )
where an asterisk denotes a foreign magnitude. That is to say,in the case of
certainty and if,for example,i > i ∗ ,arbitrageurs will be prepared to move funds
from the foreign country to the home country as long as the exchange rate for
the domestic currency is not expected to depreciate by as much as,or more than,
the interest differential. Equation (1.14) is known as uncovered (or open) interest
rate parity (UIP). In a world of certainty the expected change in the exchange
rate and the forward premium,or discount,would be identical. In conditions of
uncertainty they would differ by an amount equal to the risk premium required
to persuade speculators to fulfil forward contracts. It is important to note that
although UIP is often portrayed with rational expectations,as in (1.14 ′ ),this is an
auxiliary assumption.