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It is often said that interest rate parity determines exchange rates between currencies of different countries. If interest rate parity holds then there is no opportunity for covered interest arbitrage. This paper shows that interest rate parity holds for most part between U.S.A. and other industrialized countries, and therefore there is no opportunity for covered interest arbitrage for U.S. investors investing in the industrialized countries. The regression results show that interest rates in industrial countries depend on U.S. interest rates and (forward/Spot) rates. The same relationship is not true for interest rates of emerging markets in Asia. The regression results shows that there is absolutely no relationship between U.S. interest rate, (forward/Spot) rates and interest rates in emerging markets in Asia. Therefore it is concluded that Interest rate parity does not hold between U.S.A and the emerging markets in Asia, this offers an opportunity for covered interest arbitrage for U.S. investors and investors of other industrialized countries investing in the emerging markets in Asia. This covered interest arbitrage is possible because of significant differentials in interest rates between the industrialized countries and the emerging markets in Asia. The study shows that although the currency of most of the emerging Asian market depreciated over the eight year period against the U.S. dollar, however the interest rate differentials between U.S.A. and emerging Asian Markets was large enough to earn a positive excess return in most cases. It can be concluded that a U.S. investor can earn an excess return by investing in the emerging markets of Asia instead of investing in other industrialized countries. INTRODUCTION The theory of Interest Rate Parity (IRP) holds that one cannot make arbitrage profits due to different interest rates in different countries. Let us assume that 3 month interest rate is 9 percent in the United States and 6 percent in U.K. This would indicate that investors in Britain will transfer their funds to the United States to earn the higher return. However, the theory of interest rate parity holds that such arbitrage opportunity is not possible, because after 3 months the U.S. Dollar is expected to depreciate by about 3 percent. Therefore, the British investor is not any better off by investing in U.S.A., because of an expected 3 percent decline in the value of the U.S. dollar against the British pound. In this example interest arbitrage takes place when the British investors exchanges the British pound for U.S. dollar to invest in U.S.A to take advantage of the higher interest rates in the U.S. However, at the end of the 3 month investment period, the dollar is converted back to British pound, but because the value of the dollar declined by about 3 percent, this wipes out the gain, this is an exchange rate risk. Exchange rate risk can be covered by selling the expected dollar value to be received after the 3 month investment period in the forward market. Therefore to gain in a covered interest arbitrage a British investor must simultaneously buy dollar in the spot market and sell dollar in the forward market. This opportunity for guaranteed profit will induce all investors in Britain to buy dollar in the spot market and sell dollars in the forward market. This will increase the value of the dollar in the spot market and depreciate the value of the dollar in the forward market, until equilibrium is reached and wipes out any arbitrage profit. Therefore, whether the investor invests in U.K or U.S.A. should get the same return. Interest Rate Parity holds only at equilibrium. Arbitrage holds only when there is no investment and no risk but guaranteed profit. Let us use an example; a U.K. investor takes the following steps: 1 Borrow pound 100,000 @ 6% for 1 year. The investor incurs a liability of 106,000 pound at the end of 1 year. The investor simultaneously sells the expected dollar proceeds in the forward market at a rate of $1. … |
