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The role of covered interest parity in explaining the forward premium anomaly within a nonlinear panel framework

Dooyeon Cho

Journal of Empirical Finance, 2015, vol. 34, issue C, 229-238

Abstract: This paper investigates the dynamic properties of uncovered interest parity (UIP) depending on deviations from covered interest parity (CIP) in a nonlinear panel framework. By employing a panel smooth transition regression model, the threshold level of the CIP deviation in which UIP tends to hold is found to be outside the band of inaction where deviations from CIP would fail to be arbitraged away. This paper shows how reversals of UIP observed during the global financial crisis can be, to some extent, accounted for by funding liquidity constraints. Simulation experiments also suggest that the data-generating process from the nonlinear panel model can produce data consistent with the failure of UIP.

Keywords: Uncovered interest parity; Covered interest arbitrage; Nonlinearity; Time-varying parameter; Funding liquidity constraints; Band of inaction (search for similar items in EconPapers)
JEL-codes: C13 F31 G15 (search for similar items in EconPapers)
Date: 2015
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DOI: 10.1016/j.jempfin.2015.07.002

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Journal of Empirical Finance is currently edited by R. T. Baillie, F. C. Palm, Th. J. Vermaelen and C. C. P. Wolff

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