Disparity of Interest Rate Parity Conditions : Absolute and Relative Form Evaluated

Joseph CHENG, Abraham MULUGETTA

Research output: Journal PublicationsJournal Article (refereed)

Abstract

While Purchasing Power parity is discussed in both absolute form and relative form, it is rare to apply such distinction to interest rate parity. This paper examines the interest rate parity both in absolute and in relative forms. According to interest parity theory, for example, the Euroyen rate or Europound rate and its forward premium should equal to the Eurodollar rate in an efficient global financial market. This condition assign a theoretical value of the zero to the difference, disparity or residual in line with the covered arbitrage opportunity. Eurodollar, Euroyen and the Japanese yen futures daily closing prices are used to compute the disparity. The disparity indicates that it is statistically significantly and different from zero, implying that the interest rate parity does not hold in absolute term. Specifically, Japan has a higher rate than the U.S. even after adjusting for the currency return, which includes forward premium. Such disparity might be due to default risk differential, expected differential economic performance and probably other factors as well. Nevertheless, our study is supporting the relative or dynamic form of interest rate parity. The finding clearly shows stronger correlation between the covered return for Japan and U.S. interest rate in comparison to that of U.S. interest rate and uncovered return for Japan, that is, Japan interest rate.
Original languageEnglish
Pages (from-to)36-48
JournalJournal of Applied Financial Research
Volume1
Publication statusPublished - Jan 2018

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