The Effectiveness of Interest Rate Parity

Abstract

This paper provides an investigation as to whether there has been any improvement on the effectiveness of IRP in forecasting exchange rates in three-month periods. With AUD being the base currency, the research is conducted using nine foreign currency proxies, namely USD, JPY, GBP, CHF, NZD, CAD, HKD, SGD and CNY. Historical exchange rates of AUD over the nine foreign currencies and three-month interest rates in the ten countries from 1 January 1995 to 30 December 2008 are collected and computed. According to our results, although there is evidence suggesting that IRP generally holds, its quality does not appear to have improved in recent years. Indeed, we found strong evidence indicating that the quality of IRP is not related to the time horizon. One possible explanation to this finding might be that the recent financial crisis has triggered significant government intervention and brought incredible currency risk, deteriorating the quality of IRP.