II. Literature Review
II. 1 Covered Interest Parity
“...Forward quotations for the purchase of the currency of the dearer
money market tend to be cheaper than spot quotations by a percent per month equal
to the excess of the interest which can be earned in a month in the dearer market
over what can be earned in the cheaper.” [Keynes, 1923, p103]
Empirical literature on CIP has generally tended to validate the hypothesis for the
industrial countries, within the limits of the transaction costs and limits to speed of
adjustment due to imperfectly elastic supply of funds. Obstfeld and Taylor (2004)
compute covered interest differentials with monthly data vis-à-vis the Pound Sterling for
US and German markets for the period 1921-2003. They estimated:
F
(1 + it ) T- - (1 + it ) (6)
St
and found that the differentials were large between 1920 and 1980, but shrank
considerably after 1980 [See Figure 2]. For the period 1870-1914, they use data on
interest rates on long bills of exchange and find shrinking differences between 1870-1914
as well (another reason to expect shrinking differences now, in Emerging Economies).
Significantly, these differences became lower post 1980 than they were at the peak of the
Gold Standard. And have been falling since.. .Frankel (1991) estimated a time trend in
absolute value of covered interest differentials for 25 developed countries during the
1980’s and found a statistically significant negative trend for 10 of those 25 countries.
Other studies that have estimated the differential in (6) and tested for presence of
profitable opportunities outside of the “transfer points” include Frenkel and Levich