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A rank approach for studying cross-currency bases and the covered interest rate parity

Abstract

We use a panel rank cointegration approach to check for the stability conditions of the cross-country money market interest rate basis. Using weekly information on short-term interest rates and spot and forward exchange rates for a set of 20 European economies between 2005 and 2017, we show that in most cases these bases are non-stationary, implying the failure of the covered interest rate parity condition. Concretely, a mean-reverting behavior is encountered in only two cases. The first includes Greece, Italy and Portugal, while the second Belgium, France and Germany.

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Notes

  1. Violations of the CIP condition have been reported in emerging market economies even before the Subprime financial crisis. See, for instance, Skinner and Mason (2011).

  2. It is important to note that in this study we test for linear cointegration relationships. Given the potential reasons for deviations from the covered interest rate parity condition, there may be nonlinear cointegrating relationships (large versus small deviations) that could be accounted for using threshold autoregressive models (Balke and Fomby 1997), or strongly persistent (fractional) long-run relationships as well [see, for instance, Saikkonen and Choi (2004)].

  3. In our dataset we have both countries whose currency is the Euro and others in which not. For the former, our approach implies stationary interest rate spreads.

  4. Initially, this result could also indicate that some of the time series are I(0). However, we performed additional tests showing that this is not the case. In particular, individual unit root tests for each series were encountered.

  5. The deterministic term in Eq. (3) can be augmented with a higher degree polynomial trend function as in Pedroni et al. (2015).

  6. Untruncated in this context means that the bandwidth for the long-run variance estimator is taken to be equal to T.

  7. We assume that the long-run variance estimator is calculated using the Bartlett kernel. In this case, the expression for \(\hat{\pmb {\varOmega }}_p\) is simplified as shown by Kiefer and Vogelsang (2002).

  8. From a theoretical point of view, results should be identical regardless of whether bilateral exchange rates (spot and forward) are considered with respect to the US dollar or the Euro. Small differences could be observed if the liquidity of spot and forward exchange rate markets was significantly different, but for exchange rates between non-Euro European countries with respect to the US dollar and the Euro this is not the case. See, for instance, Barkoulas et al. (1997).

  9. Similar results are obtained when the system Johansen cointegration procedure is used instead.

  10. For instance, Baba and Packer (2009) attribute the failure of CIP during the global financial crisis to differences in counterparty risk between European and US financial institutions, while Coffey et al. (2009) call the attention on the existence of capital constraints.

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Correspondence to Jose E. Gomez-Gonzalez.

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We thank Robert Kunst and two anonymous referees for their insightful comments that were very useful in improving our document. The opinions expressed here are those of the authors and do not represent those of the Banco de la República or its Board of Directors. The usual disclaimers apply.

Appendix A: countries considered

Appendix A: countries considered

See Table 5.

Table 5 Countries

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Gomez-Gonzalez, J.E., Gomez-Malagon, S., Melo-Velandia, L.F. et al. A rank approach for studying cross-currency bases and the covered interest rate parity. Empir Econ 59, 357–369 (2020). https://doi.org/10.1007/s00181-019-01633-4

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  • DOI: https://doi.org/10.1007/s00181-019-01633-4

Keywords

  • Covered interest rate parity
  • Nonparametric rank tests
  • Cointegration
  • Time series panel
  • Cross-currency basis

JEL Classification

  • C12
  • C33
  • E43