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.
The Interest Rate Parity (IRP) condition is a commonly employed technique in making exchange rates forecasts. Forecasts under this condition are made by inputting the spot exchange rates and the interest rates in the domestic and foreign countries respectively. Therefore the reliability of this technique is highly related to how the two interest rates are affected. In recent years, as the world becomes more internationally related, interest rates are no longer determined solely by countries’ domestic economic factors. Since the quality of IRP is positively connected to the level of the global financial market integration, it is reasonable to expect an improvement in the quality of IRP compared with a decade ago.
This paper aims to test whether the performance of IRP in forecasting exchange rates in three-month periods has improved recently. This requires quantitative measures. With AUD being the domestic currency, nine currencies (including USD in the US, JPY in Japan, GBP in the UK, CHF in Switzerland, NZD in New Zealand, CAD in Canada, HKD in Hong Kong, SGD in Singapore, and CNY in China) are used as foreign currency proxies over which exchange rates of AUD are to be forecasted. Data of spot exchange rates, domestic interests and foreign interests for the period 1995-2008 were collected from reserve banks of the ten countries in discussion.
