Question

Give 3 reasons for deviations from Interest Rate Parity. Do these deviations indicate unexploited profit opportunities for investors?

Answer 1

Covered interest rate parity (CIP) is the condition that requires the interest rates to be the same across countries once the exchange rate risk has been hedged away

Three reasons for deviation from interest rate parity are:

• Transaction cost: The process helps in bringing the interest rates and exchange rates into a line. The cost involved in relation to investment and borrowing are money market transaction cost and other. This transaction cost hinder arbitrage across countries. Thus, CIP may show deviations.
• Political Risk: This involves  influence of government policies on stock prices and the risk related to announcements of policy changes that would lead to a drop in the equity prices on average, with an analogous increase in the volatility and the correlation.
• Differential tax rate: This means earnings on account of transactions in foreign currency are treated as capital gains, in home country or in foreign country, and hence are taxed at rates different from the rates applicable to interest income, though higher or lower.

Such deviations do indicate unexploited profit oppurtunities for investors. Various studies have indicated that it occur due to market inefficiency. This implies that transaction costs, demand and supply elasticities in the various markets and lags in executing arbitrage account for all of the apparent profit opportunities.