Covered Interest Rate Parity

Abstract

The idea of covered interest rate parity (CIP) states that simultaneous purchase and sale of two currencies should not result in profit. This parity condition is examined using error correction model (ECM), descriptive analysis of profitable deviations and impulse response functions from the vector error correction model (VECM). This study on average finds support for the parity condition. However, there is also evidence for some rare but large deviations. Majority of the profitable deviations are small in size. Results for persistence of the profitable deviations are mixed. These results suggests that there is not sufficient evidence for either accepting or rejecting the CIP and efficiency of the market. Thus, this paper is inconclusive regarding the validity of CIP and efficiency of the market.