Decomposition of Interest Rate Differentials (in Korean)

Bok-Keun Yu () and Hwagyun Kim ()
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Bok-Keun Yu: Economic Research Institute, The Bank of Korea
Hwagyun Kim: Texas A&M University

Economic Analysis (Quarterly), 2009, vol. 15, issue 2, 97-135

Abstract: The interest rate parity theorem suggests that the related financial assets that are otherwise identical among nations should have the same returns. However, according to empirical evidence systematic deviations from the parity conditions are often observed, which are ascribed to differences among countries in currency factors, taxes, transaction costs and country risks. In an attempt to better understand and quantify the nature of these deviations, we examine the main characteristics and possible causes of interest rate differentials, especially with the U.S., for twelve sample countries over two periods from the 2000s selected based upon the trends (upward and downward) of U.S. interest rates. In addition, we analyze the impact of the recent global financial crisis triggered by the U.S. sub-prime mortgage insolvencies by categorizing the period from August 2007, when the crisis began in earnest, until now as the 'financially distressed period.' We find that the interest rates of most sample countries induced by their monetary policy changes are more in sync with those of the U.S. during the period when the U.S. interest rate moved upward. Most of the interest rate differentials can be explained by currency factors during both the upward and downward periods. However, during the financially distressed period the effect of the country factors increased significantly among most sample countries. Furthermore, the test results show that the covered interest parity condition holds in most advanced countries, while it does not hold in the emerging market countries. This implies that the recent global financial crisis has had disproportionately bigger effects on emerging market countries than on developed countries, in light of the country risk and currency liquidity of each country.

Keywords: Interest Rate Differential; Country Factor; Currency Factor; Covered Interest Rate Differential; Exchange Rate Risk Premium; Interest Rate Parity (search for similar items in EconPapers)
JEL-codes: E52 F30 G15 (search for similar items in EconPapers)
Date: 2009
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Persistent link: https://EconPapers.repec.org/RePEc:bok:journl:v:15:y:2009:i:2:p:97-135

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