International macroe.. - Free

1.1. INTERNATIONAL FINANCIAL MARKETS 7tions costs are ¯C(1 + i ∗ )(F/S). The arbitrage is unproÞtable if¯C(1 + i ∗ )(F/S) ≤ (1 + i), or equivalently iff p ≤ ¯f p ≡ (1 + i) − ¯C(1 + i ∗ ). (1.4)¯C(1 + i ∗ )By the analogous argument, it follows that an arbitrage that is long inthe dollar remains unproÞtable iff p ≥ f p≡ ¯C(1 + i) − (1 + i ∗ ). (1.5)(1 + i ∗ )[f p, ¯f p ]deÞne a neutral band of activity within which f p can ßuctuatebut still present no proÞtable covered interest arbitrage opportunities.The neutral-band analysis proceeds by estimating the transactions costs¯C. These are then used to compute the bands [f p, ¯f p ] at various pointsin time. Once the bands have been computed, an examination of theproportion of actual f p that lie within the bands can be conducted.Frenkel and Levich estimate τ s and τ f to be the upper 95 percentileof the absolute deviation from spot and 90-day forward triangular arbitrage.τ is set to 1.25 times the ask-bid spread on 90-day treasurybills and they set τ ∗ = τ. They examine covered interest parity for thedollar, Canadian dollar, pound, and the deutschemark. The sampleis broken into three periods. The Þrst period is the tranquil peg precedingBritish devaluation from January 1962—November 1967. Theirestimates of τ s range from 0.051% to 0.058%, and their estimates of τ frange from 0.068% to 0.076%. For securities, they estimate τ = τ ∗ tobe approximately 0.019%. The total cost of transactions fall in a rangefrom 0.145% to 0.15%. Approximately 87% of the f p observations liewithin the neutral band.Thesecondperiodistheturbulent peg from January 1968 to December1969, during which their estimate of ¯C rises to approximately0.24%. Now, violations of covered interest parity are more pervasivewith the proportion of f p that lie within the neutral band ranging from0.33 to 0.67.The third period considered is the managed ßoat from July 1973 toMay 1975. Their estimates for ¯C rises to about 1%, and the proportion