One-Way Arbitrage-Based Interest Parity

Rosita P. Chang, Sang-Hyop Lee, Sean F. Reid and S. Ghon Rhee ()
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Rosita P. Chang: University of Hawai'i
Sean F. Reid: University of New Haven
S. Ghon Rhee: University of Hawai'i

No 02-115/2, Tinbergen Institute Discussion Papers from Tinbergen Institute

Abstract: This study is motivated by two major considerations. First, the Fletcher andTaylor (1996) approach has yet to be applied to short-date markets to assess thediminishing role of transaction costs in explaining the devjatjons of observed forwardforeign exchange prices from interest parity forward prices. Second, the role oftransaction costs in one-way arbitrage-based interest parity has not been examined.Applying the Fletcher and Taylor approach to one-way arbitrage-based interest parity inshort-date capital markets, we document three major findings: (i) a narrower neutralband around interest parity line, as implied by one-way arbitrage, does not diminish therole of transaction costs; (ii) the varjances of the estimated deviations are a decreasingfunction of the time spent outside the transactions cost band; and (iii) the magnitude ofarbitrage profits tends to be small and economically insignificant though profitableopportunities are not rare in the short-date markets studied.

Date: 2002-12-02
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