Study on feasibility of carry trade - Validation of interest rate parity based on the smooth transition autoregressive model
Date Issued
2010
Date
2010
Author(s)
Tsai, Chung-Heng
Abstract
This empirical study of Covered Interest Rate Parity (CIRP) is conducted on the basis of non-linear Smooth Transition Autoregressive Model, focusing on five areas including Japan, the United States, Australia, the United Kingdom, and the Euro zone. When CIRP holds, no abnormal gain can be derived from carry trade; in contrast, when CIRP cannot be supported, capital holders can obtain abnormal profit from carry trade.
The result demonstrates that a linear relationship exists in the difference (D) between interest spread and forward exchange rate discount (or premium) of the Euro zone and Japan. In the cases of Australia against Japan and the UK against Japan, STAR model can be used to describe the process of adjustment for D`s deviation. While the high speed of transition (γ) of the United States against Japan causes STAR model to recede to TAR model. These three non-linear models possess excellent predictive power, according to the root mean square error.
In the forecasted periods, CIRPs of the United States against Japan and the UK against Japan sustain in nearly all periods, suggesting the financial markets and the foreign exchange markets are efficient. Therefore, capital holders cannot obtain abnormal profit from carry trade. In the case of Australia against Japan, CIRP can be supported only in the initial periods. Then it gradually deviates from CIPR equilibrium in the long term, causing inefficiency of the financial markets and the foreign exchange markets. Hence, investors can obtain abnormal profit from carry trade.
Subjects
nonlinearity
smooth transition autoregressive
carry trade
covered interest parity
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