A nonparametric general equilibrium estimation of covered interest rate arbitrage for western European countries during the pre-euro period: a behavioural perspective

Hsiou-Wei Lin and Yun Chiang Tai

Applied Financial Economics, 2009, vol. 19, issue 15, 1223-1237

Abstract: In this article, the nonparametric threshold autoregressive model for the Covered Interest Rate Parity (CIP) deviation is proposed. We provide a threshold estimation under the general equilibrium framework. The Keynes-Einzig conjecture based on market observation is verified. Within thresholds, the momentum effect holds. The behavioural finance applies as the aggregated data are used. Outside thresholds, the random process is shown from our general equilibrium estimation. Our estimations show that the CIP deviation is nonstationary within thresholds for some countries. It contradicts to the limit of arbitrages and other market frictions for the threshold trading. The robustness test has been performed to reconfirm our results based on the Mean Absolute Error (MAE) criterion. The implication shows that the trend-following exists within thresholds and the directionless moving as the threshold is reached. Behind our estimation, it shows that the threshold forms a new equilibrium. As the nonparametric general equilibrium is pursued, the interactive effects behind the parameters estimation are also discussed. In this article, we provide a behavioural perspective about the real exchange rate in terms of covered interest rate parity to show the meaning behind the Keynes-Einzig conjecture. We also provide the estimation of latest aggregated data for comparison. It shows structural changes as the euro is adopted.

Date: 2009
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DOI: 10.1080/09603100802403626

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