Arbitrage, Covered Interest Parity and Long-Term Dependence between the Us Dollar and the Yen

32 Pages Posted: 12 Aug 2006

Date Written: March 2006

Abstract

Using a daily time series from 1983 to 2005 of currency prices in spot and forward USD/Yen markets and matching equivalent maturity short term US and Japanese interest rates, we investigate the sensitivity over the sample period of the difference between actual prices in forward markets to those calculated from short term interest rates. According to a fundamental theorem in financial economics termed covered interest parity (CIP) the actual and estimated prices should be identical once transaction and other costs are accommodated.

The paper presents four important findings: First, we find evidence of considerable variation in CIP deviations from equilibrium that tends to be one way and favours those market participants with the ability to borrow US dollars (and subsequently lend yen). Second, these deviations have diminished significantly and by 2000 have been almost eliminated. We attribute this to the effects of electronic trading and pricing systems. Third, regression analysis reveals that interday negative changes in spot exchange rates, positive changes in US interest rates and negative changes in yen interest rates generally affect the deviation from CIP more than changes in interday volatility. Finally, the presence of long-term dependence in the CIP deviations over time is investigated to provide an insight into the equilibrium dynamics. Using a local Hurst exponent - a statistic used in fractal geometry - we find episodes of both positive and negative dependence over the various sample periods, which appear to be linked to episodes of dollar decline/yen appreciation, or vice versa. The presence of negative dependence is consistent with the actions of arbitrageurs successfully maintaining the long-term CIP equilibrium. Given the time varying nature of the deviations from equilibrium the sample period under investigation remains a critical issue when investigating the presence of longterm dependence.

Keywords: Hurst exponent, Efficient market hypothesis

JEL Classification: C22, C32, E31, F31

Suggested Citation

Batten, Jonathan A. and Szilagyi, Peter G., Arbitrage, Covered Interest Parity and Long-Term Dependence between the Us Dollar and the Yen (March 2006). IIIS Discussion Paper No. 128, Available at SSRN: https://ssrn.com/abstract=923769 or http://dx.doi.org/10.2139/ssrn.923769

Jonathan A. Batten

RMIT University ( email )

Level 12, 239 Bourke Street
Melbourne, Victoria
Australia

HOME PAGE: http://https://www.rmit.edu.au/contact/staff-contacts/academic-staff/b/batten-professor-jonathan

Peter G. Szilagyi (Contact Author)

EDHEC Business School ( email )

24 Av. Gustave Delory
Roubaix, 59057
France

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