How to Determine Whether the Interest Rate Parity (IRP) Holds
The IRP indicates a long-run relationship between interest rate differentials and forward premium or discount. Although at any given time this relationship may not hold, if appropriate estimation techniques are applied to long-enough data, you would expect the results to verify the IRP. In reality, things don’t work this smoothly. Factors interfere with the empirical verification of the IRP.
Empirical evidence on IRP
The empirical verification of the IRP depends upon the approach. Empirical studies using forward rates seem to have a better chance of showing that the IRP exists. In other words, empirical results suggest that deviations from the IRP aren’t large enough to make covered interest arbitrage profitable.
However, when empirical studies use interest rate differentials between two countries, the results suggest that interest rates aren’t consistently good predictors of changes in exchange rates, especially larger ones.
The results also differ depending on whether we try to predict short- or long-term changes in exchange rates. Empirical evidence indicates that macro-economic fundamentals have little explanatory power for changes in exchange rates up to a year.
In fact, random walk models of exchange rates seem to outperform macroeconomic fundamentals-based models of exchange rate determination. This is not very good news for macroeconomic models, if you consider what a random walk model is. A random walk model of exchange rates calculates the next period’s exchange rate as today’s exchange rate with some unpredictable error.
Factors that interfere with IRP
A variety of risks associated with a currency make a security denominated in this currency an imperfect substitute to another country’s security.
The term political risk includes different categories of risks, which makes securities denominated in different currencies imperfect substitutes. Certain domestic or international events may motivate governments to introduce restrictions on incoming foreign portfolio investments. Or particular events or policies in a country may increase the country’s default risk, as perceived by foreign investors. Likewise, differences in tax laws may cause concern among investors regarding their after-tax returns.
Other reasons also exist. Sometimes markets’ observed preference for certain currencies cannot be explained based on interest rates differentials. The Swiss franc is a good example in this respect. Usually when most developed economies go through a recession, the Swiss franc appears to be the go-to currency, even though interest rate differentials suggest otherwise. This fact may reflect the liquidity preference of some international investors during periods of slower global growth.
Additionally, there is the so-called carry trade. It means borrowing in a low-interest-rate currency and investing in a high-interest-rate currency. Carry trade is very risky and is not consistent with the IRP. This kind of international investment appreciates the currency of the country with higher nominal interest rates, which goes against the predictions of the IRP.
All of these factors contribute to the weakening of the IRP-suggested relationship between interest rates and changes in the exchange rate.