An Empirical Study of Covered Interest Arbitrage_ Marqins Durinq

7/27/2019 An Empirical Study of Covered Interest Arbitrage_ Marqins Durinq

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Honors Projects Economics Department

1994

An Empirical study of Covered Interest Arbitrage:Marqins Durinq the European Monetary System

Crisis of 1992Ossi Saarinen '94 Illinois Wesleyan University

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Recommended CitationSaarinen '94, Ossi, "An Empirical study of Covered Interest Arbitrage: Marqins Durinq the European Monetary System Crisis of 1992"(1994).Honors Projects.Paper 52.h p://digitalcommons.iwu.edu/econ_honproj/52
http://digitalcommons.iwu.edu/http://digitalcommons.iwu.edu/econ_honprojhttp://digitalcommons.iwu.edu/economicsmailto:[email protected]:[email protected]://digitalcommons.iwu.edu/economicshttp://digitalcommons.iwu.edu/econ_honprojhttp://digitalcommons.iwu.edu/


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An Empirical study o f Covered In t e res t Arbitraqe:Marqins Durinq th e European Monetary system Cr i s i s o f 1992.

Research HonorsMay 1 8 , 1994

Oss i Saarinen


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I . In t roduc t ion

I n t e r e s t p a r i t y in i n t e r n a t i o n a l f i nanc i a l markets e x i s t s

when th e i n t e r e s t r a t e d i f f e r e n t i a l between tw o coun t ies i s

exac t ly o f f s e t by the forward exchange premium/discount . I f a t

any moment the i n t e r e s t p a r i t y condi t ion i s not s a t i s f i e d ,

t r a d e r s can execute covered i n t e r e s t a r b i t r a g e . Covered i n t e r e s t

a r b i t r a g e e n t a i l s a s e r i e s o f four t r ansac t ions i n th e currency

and s e c u r i t i e s markets which r e s u l t s in a p r a c t i c a l l y r i s k l e s s

p r o f i t . Although t r a d i t i o n a l economic theory p r e d i c t s t h a t th e

oppor tun i t i e s w i l l be wiped out as ind iv idua l s take advantage o f

th e s i t u a t i o n , covered i n t e r e s t . a rb i t rage margins (ClAMs) have

been observed t o e x i s t over extended p e r io d s o f t ime.

Previous research in the area has at tempted t o r e c t i f y th e

discrepancy by ; iden t i fy ing fac to rs ou ts ide t he bas i c a r b i t r a g e

equat ion which work t o negate p r o f i t oppor tun i t i e s . The most

dominant of such fac to rs i n th e l i t e r a t u r e have been t r a n sa c t i o n s

c o s t s , par t ly because they a re q u a n t i f i a b l e . Other f a c t o r s , such

as p o l i t i c a l/ f i n a n c i a l - c e n t e r r i s k , t iming problems, and

imperfect e l a s t i c i t i e s of demand an d supply have been explored as

well , but a re more d i f f i c u l t t o p in down empi r ica l ly.

My research i s an at tempt to determine whether t r a n sa c t i o n s

cos t s a re enough t o expla in away ClAMs, o r i f

p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k a l so plays an impor tan t r o l e .

The focus i s on th e t ime per iod summer/ fal l 1992 when th e

European Monetary System c r i s i s occurred, br ing ing along wi th i t

heavy specu la t ion , v o l a t i l i t y , and i n t e rven t ion i n th e currency

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markets . A h igher p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k fo r London i s

hypothes ized t o e x i s t dur ing t h i s t ime p e r io d , c r e a t i n g th e

p o s s i b i l i t y o f margins t h a t cannot be expla ined away by s imple

t r ansac t ions cos t s alone, and t h u s p r e sen t in g an i d e a l t ime fo r

f u r t h e r s tudy.

Overal l , th e r e s u l t s of the research sugges t t h a t

t r ansac t ions cos t s may indeed be enough t o ex p la in away margins

between developed f i n a n c i a l c e n t e r s such as London and New York,

but are inconclus ive u n t i l b e t t e r data i s ob ta ined .

I I . B a s i c Theory

I f i n t e r e s t p a r i t y does not hold , covered i n t e r e s t a r b i t r a g e

margins appear and r i s k l e s s a r b i t r a g e i s p o s s i b l e . For example,

i f a negat ive margin i s found t o e x i s t between New York and

London, a t r a d e r may execu te th e fo l lowing s e t o f t r a n sa c t i o n s

fo r a p r o f i t :

1) borrow d o l l a r s on th e u.s. market a t a lower r a t e o fi n t e r e s t ,

2) exchange d o l l a r s fo r B r i t i s h pounds on th e s p o t marke t ,3) purchase h ig h e r y i e l d B r i t i s h s e c u r i t i e s , and4) e n t e r a forward c o n t r a c t o f corresponding matur i ty t o bUy

back d o l l a r s .

This s e r i e s o f t r ansac t ions i s in i t s e l f r i s k l e s s i n t h a t th e

exchange r a t e exposure has been nUl l i f i ed , thus guaran tee ing a

p r o f i t a t matur i ty r egard les s o f changes in exchange r a t e s .

Simple supply and demand reason ing l e ad s us t o be l ieve t h a t

th e p r o f i t oppor tuni ty should be sh o r t - l i v e d . As t r a d e r s engage

i n th e t r a n s a c t i o n s , p ressu re i s appl ied on each component i n

such a way t h a t th e i n t e r e s t d i f f e r e n t i a l and forward

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premium/discount produce p a r i t y . For example, th e purchase of

pounds and s a l e o f d o l l a r s on th e spo t market causes th e d o l l a r

exchange r a t e t o weaken. I t w i l l consequen t ly cos t i nd iv idua l s

more to purchase pounds, adding to c o s t s an d reducing p r o f i t .

Simi la r ly, an increased flow o f funds t o London and th e

subsequent purchase o f s e c u r i t i e s causes th e i n t e r e s t r a t e on

these s e c u r i t i e s t o f a l l , a l so decreas ing th e amount of p r o f i t

genera ted by a r b i t r a g e . The same reasoning app l ies fo r t he u .S .

i n t e r e s t r a t e s as wel l as th e forward exchange r a t e . These s o r t s

o f changes cont inue u n t i l i n t e r e s t p a r i t y i s brough t about and

inves to r s a re i n d i f f e r e n t t o covered i n t e r e s t a r b i t r a g e .

What t h i s then sugges t s i s t h a t i f people do a c t r a t i o n a l l y

i . e . by tak ing advantage o f p r o f i t oppor tun i t i e s , ClAMs shou ld

not be observed. I t i s an es t ab l i shed f a c t , however, t h a t margins

e x i s t in r e a l l i f e . For example, Grubel ca l cu l a t ed margins fo r

th e t ime per iod of 1956 t o 1960 and found them to dev ia t e from

p a r i t y a t a range between negat ive two and f ive pe rcen t

annual ized (pg. 80) . More r ecen t sources such as Salva to re (pg.

397) and Rivera-Bat iz (pg. 109) a l so a t t e s t t o th e f a c t t h a t

ClAMs e x i s t .

I I I . Account ing fo r Observed Margins

A. Market I n e f f i c i e n c y

Early research in th e area sough t t o f j n d e x p l a n a t i o n s fo r

th e ClAMs i n th e markets t hemselves . I t was reasoned t h a t t h e

markets were n o t sUff i c i en t ly e f f i c i e n t so as t o a c t in a way

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t h a t could e l imina te ClAMs. This was i n th e t ime of t he gold

s tandard and f ixed exchange r a t e s . Although t he se may have been

v a l i d fac to rs fo r ty years ago in r e l a t i v e l y under-developed

markets , t o d a y ' s f i nanc i a l markets a re v a s t l y d i f f e r e n t . Global

communications and computerized t r ad ing ensure almost

ins tan taneous access to th e markets . Simi la r ly, th e i n t e r n a t i o n a l

flow of c a p i t a l has been deregu la ted to such an e x t e n t t h a t s h o r t

term funds a re f r ee to move between major f i n a n c i a l c e n t e r s

without obs t ac l e s . Thus, t he roo t s of th e p e r s i s t e n c e o f ClAMs

are u n l i k e l y t o be found i n i n e f f i c i e n t markets and obs t ac l e s t o

t r ansac t ing . 1

There e x i s t tw o o ther major views o r explana t ions o f ClAMs,

each o f which w i l l be cons idered sepa ra t e ly i n t h i s se c t i o n . One

o f them has been extens ively explored by Frenkel and Levich, th e

o ther by Grubel . I do no t wish to sugges t t h a t e i t h e r explana t ion

"belongs" o r i s so l e ly represen ted by these people . Rather, f6 r

th e sake of s imp l i c i t y and convenience , th e theory o f

t ransac t ions cos t s w i l l be mainly as soc ia ted with Frenkel and

Levich whi le t h a t o f add i t i ona l r i s k s with Grubel .

B. Transac t ions c o s t s and th e Neutra l Band

Frenkel and Levich d id not inven t th e concept o f

1 The subsequent use of th e concept o f e f f i c i e n c y in t h i spaper i s more genera l ized than th e s t r i c t d e f i n i t i o n found ineconomics / f inance. By claiming t h a t markets a re e f f i c i e n t i t i ssimply meant t h a t when faced with poss ib le p r o f i t o p p o r t u n i t i e s ,people a c t r a t i o n a l l y.


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t r a n s a c t i o n s c o s t s as they were a l ready cons idered i n th e

o r i g i n a l piece on covered i n t e r e s t a r b i t r a g e , Keynes ' A Trac t on

Monetary Reform, bu t the m ajo r i ty o f modern l i t e r a t u r e dea l ing

with t r ansac t ions cos t s has been wr i t t e n by Frenke l and Levich.

The concept o f t r ansac t ions cos t s stems from the f a c t t h a t

ex te rna l cos t s not e x p l i c i t i n th e covered i n t e r e s t a r b i t r a g e

formula i t s e l f e x i s t . These cos t s inc lude such th ings as

brokerage f ees , t ime cos t s , subsc r ip t ion cos t s , and th e c o s t s o f

being informed. I f in sum these expenses a re g r e a t e r than th e

poss ib le p r o f i t der ived from i n t e r e s t a r b i t r a g e , no r a t i o n a l

inves to r w i l l execu te the a r b i t r a g e . Thus, smal l margins cou ld

e x i s t fo r extended per iods o f t ime as almost an i l l u s i o n - - e x a c t

i n t e r e s t p a r i t y does n o t hold , b u t in e f f e c t i n t e r e s t a r b i t r a g e

i s not p r o f i t a b l e .

The i n t e r e s t p a r i t y l i n e can be seen in graph ica l form in

Figure 1 (see end o f paper fo r a l l Fig u re s ) . Any p o i n t no t ly ing

on t h i s 45 degree l i n e does not s a t i s f y th e p a r i t y co n d i t io n ,

i . e . th e i n t e r e s t d i f f e r e n t i a l i s no t ex ac t ly o f f s e t by th e

discount/premium on fore ign exchange. The ex i s t en ce o f

t r a n s a c t i o n s c o s t s can be seen t o c rea t e a neu t ra l band around

th e i n t e r e s t p a r i t y l i n e (F igure 2 ) . Any po in t conta ined wi th in

t h i s band would no t r ep re sen t a p r o f i t oppor tuni ty as th e c o s t s

o f t r ansac t ing would outweigh th e p o t e n t i a l r e t u r n s . Such p o i n t sa re cons idered t o a t t e s t t o th e ex i s t en ce of func t iona l i n t e r e s t

p a r i t y, whereas i f p o in t s e x i s t o u t s id e th e n e u t r a l band, th e

i n t e r e s t p a r i t y condi t ion i s n ot s a t i s f i e d . Keynes b e l i ev ed t h a t

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the y i e l d advantage had to be in excess of 0.5% annualized t o

induce any f lows. Subsequent empir ica l es t imates have placed th e

number between 0.18% (Branson 1968) and 0.25% (Holmes and

Scho t t ) .In func t iona l no ta t ion , we can def ine th e n e u t r a l band as :

where i d ~ = domestic i n t e r e s t r a t ei fe r = fo re ign i n t e r e s t r a t esp= spo t exchange r a t efw= f ~ r w a r d exchange r a t et ~ and t sp = t r ansac t ions cos t s in currency marketst d ~ and t fe r = t r ansac t ions cos t s in s e c u r i t i e s markets .

This i nequa l i t y b a s i c a l l y s t a t e s t h a t fo r i n t e r e s t p a r i t y t o hold

in e f f e c t , th e sum of t he t ransac t ions cos t s in cu r renc i e s and

s e c u r i t i e s markets must be g r e a t e r than o r equal t o th e p r o f i t

margin der ivab le from i n t e r e s t a r b i t r a g e .

c. o u t s i d e R i s k s

Grubel ' s work takes a d i s t i n c t l y d i f f e r e n t approach t o

so lv ing th e dilemma. Modern P o r t f o l i o theory, a s developed by

Tobin, forms th e backbone o f h i s explana t ion fo r why ClAMs e x i s t .

The bas i c premise i s t h a t th e demand fo r any s e c u r i t y i s a

funct ion of t he expected r e tu rn an d r i s k assoc i a t ed with hold ing

i t . I n i t i a l l y , i f t he re i s a s l i g h t earn ings advan tage in favor

of a fo re ign secur i ty th e flow of funds w i l l be quick t o e x p l o i t

i t . However, i t t akes a higher and higher expected r e t u r n t o

induce more funds because of t he r i s k as soc ia ted with hold ing too


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much o f one a s s e t . Thus, th e supply of a r b i t r a g e funds i s n ot

p e r f e c t l y e l a s t i c (Grubel 15-18) .

In t imes o f r e l a t i v e calm i n i n t e r n a t i o n a l markets , t h i s

imperfect ion i s assumed n o t t o cause ClAMs. But, dur ing t imes o f

heavy specu la t ion and v o l a t i l i t y , i n t e r e s t p a r i t y may be

d is rup ted . Act iv i ty i n t he forward exchange marke t s i s the c h i e f

source o f the d i s rup t ion . As evidence fo r h i s view Grubel c i t e s

th e Suez Canal c r i s i s of 1957 when heavy s p e c u l a t i o n aga in s t t he

pound ex i s t ed , and ClAMs were observed t o e x i s t fo r a long

p e r io d .

A n o n - t ech n ica l exp l i ca t i on o f the ou t s ide r i s k s assoc i a t ed

wi th covered i n t e r e s t a r b i t r a g e may help shed some more l i g h t on

th e mat te r. Covered i n t e r e s t a r b i t r a g e i s r i s k l e s s only i n th e

sense t h a t exchange r a t e r i s k has been n Ul l i f i e d , n o t in th e

sense t h a t t he re are abso lu te ly no o ther r i s k s involved with i t .

Two bas i c cons ide ra t ions a re behind the p o r t f o l i o approach.

F i r s t , th e f a c t t h a t funds are t i e d up fo r a d e f i n i t e amount o f

t ime adds r i s k t o covered i n t e r e s t a r b i t r a g e t h a t i s n o t i n h e r e n t

in th e t r ansac t ions t hemselves . Anytime funds a re t i e d up, a

c e r t a i n amount o f r i s k i s ad d ed - - fo r example, oppor tun i t i e s with

h ig h e r re tu rns cou ld a r i s e , or the money might be needed

elsewhere. Second, the h ig h e r th e propor t ion o f p o r t f o l i o

i nves tmen t s held i n an y s i n g l e a s s e t i s , the l e s s d i v e r s i f i c a t i o n

t he re i s , and c l e a r l y t h i s i s a l so a r i s k cons ide ra t i on . These

tw o ou ts ide r i s k s e x i s t rega rd l e ss o f th e t ime per iod under

cons ide ra t ion . They are a lmos t imposs ib le t o quan t i fy, and thus

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canno t be explored i n th e em p i r i ca l sec t ion e x p l i c i t l y. There

e x i s t s a t h i r d type of outs ide r i s k , however, t h a t presen t s an

o p p o r tu n i ty fo r empir ica l i nves t iga t ion .

The t h i r d ou ts ide r i s k , which i s explored by Frenkel and

Levich i n t h e i r empir ica l s t u d i e s an d hin ted a t by Grubel a s

wel l , i s t h a t of p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k . I n t e r n a t i o n a l

investments always carry with them an add i t i ona l r i s k

cons ide ra t ion which stems from the f a c t t h a t fo re ign governments

a re sovere ign (Rivera-Bat iz pg. 115). In o the r words, a u . s .

i nves to r h a s no guarantee t h a t h i s funds a re sa fe when inves ted

abroad. Each f i nanc i a l c e n t e r c a r r i e s with i t a p e rce iv ed amount

of r i s k which inves tors must be compensated fo r in terms of

h ig h e r r e tu rns i f they a re t o i nves t t h e r e . Obviously, th e

p o l i t i c a l and f i nanc i a l s t a b i l i t y o f th e United s t a t e s al lows i t

t o o f f e r much lower r a t e s than say Hungary as fa r as foreign

i nves to rs a re concerned.

The d i ffe rence i n s t a b l e t imes between London and New York

may be minimal, b u t in v o l a t i l e t imes t h i s i s no t necessa r i ly so .

I f e i t h e r were t o experience i n s t a b i l i t y, i t would consequent ly

be assoc ia ted with a h ig h e r p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k . Thus

in t h i s sense covered i n t e r e s t arb i t r age i s no t e n t i r e l y r i s k

f ree e i t h e r . There c l e a r l y e x i s t ou ts ide r i s k s - - c a p i t a l c o n t r o l s ,

f i n a n c i a l system col lapse , r e p a t r i a t i o n problems e t c . - - t h a tbecome more l i k e l y in t imes o f turbulence.

ThUS, what we ga ther from t h i s d iscus s ion i s t h a t i t i s

poss ib l e t h a t ou ts ide r i s k s can keep i nves to rs from t ak ing

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advantage o f covered i n t e r e s t a rb i t rage and cause margins to

p e r s i s t , espec i a l l y i n v o l a t i l e and t u rbu len t t imes .

IV. Descr ipt ion o f Time Period

In t h i s study I wish to examine th e r o l e these tw o

explana t ions ( t ransac t ions cos t an d ou ts ide r i sk ) played i n

determining i n t e r e s t p a r i t y during th e t ime o f th e European

Monetary c r i s i s o f 1992. The summer and f a l l o f 1992 were

charac te r i zed by a tremendous amount o f tu rbu lence i n Europe t h a t

der ived from both economic and p o l i t i c a l spheres .

German i n t e r e s t r a t e s were,kept h igh by th e Bundesbank i n an

e f f o r t to keep i n f l a t i o n a r y p ressu re s r e su l t i n g from r e -

u n i f i c a t i o n i n check 2 The o the r members o f th e European Exchange

Rate Mechanism (ERM) were s t rugg l ing with t h e i r own economic

r ecover ies and thus would have wished t o lower i n t e r e s t r a t e s as

a s t imulus . Yet th e ERM requ i red t h a t exchange r a t e s of member

coun t r i e s f l u c t u a t e wi th in a narrow band, and lower i n t e r e s t

r a t e s compared to Germany would have caused t h i s band to be

broken by many cur renc ies . Simul taneously, t h e r e e x i s t e d

p o l i t i c a l f r i c t i o n over th e r a t i f i c a t i o n o f th e Maast r ich t

Trea ty. Al l these fac to rs re su l t ed i n v o l a t i l i t y , specu la t i on ,

and tu rbu lence . The pres su re on th e B r i t i s h pound f i n a l l y proved

too g r e a t to q u e l l . Despi te heavy i n t e rven t ion on i t s beha l f , th epound was s e t to f l o a t as Br i t a i n dis jo ined , th e ERM i n d e f i n i t e l y

2 The even ts o f 1992 a re from Bank o f England Quar te r lyBul l e t i n , November 1992.

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on September 16, 1992.

Since during t h i s same per iod th e un i ted S t a t e s enjoyed a

per iod o f calm, London i s assumed t o have a higher

p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k as soc ia ted with i t . Tying

toge the r ou r previous discourse , we reach the fo l lowing synopsis .

I f p o l i t i c a l /f i n a n c i a l - c e n t e r r i s k does i n f a c t lead t o l a r g e r

and more p e r s i s t e n t ClAMs, t h i s should d e f i n i t e l y be ev id en t

during o ur per iod o f s tudy because o f i t s v o l a t i l e na tu re . Yet i f

t r ansac t ions cos t s do an adequate job o f accoun t ing fo r t he

margins between New York and London even in summer/ fal l o f 1992,

they probably c o n s t i t u t e a s a t i s f a c t o r y explana t ion in normal

t imes as we l l .

v. Da ta

Th e ca l cu l a t i on o f covered i n t e r e s t a r b i t r a g e margins and

t r ansac t ions c o s t s r equ i re d a ta on domestic and fo re ign i n t e r e s t

r a t e s , sp o t and forward exchange r a t e s , and b id and ask p r i c e s on

s e c u r i t i e s . The t a b l e on th e fo l lowing page i nd i ca t e s exac t ly how

each va r i ab l e i s def ined .

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- I n t e r e s t R ates - Trad i t iona l Pa i r o f S e c u r i t i e s :i d ~ u . s . 90-day Treasu ry -Bi l l r a t e .i t : o r U.K. 90-day Treasu ry -Bi l l r a t e .

- I n t e r e s t Rates- Non-Trad i t iona l P a i r o f S e c u r i t i e s :i d ~ 90-day Eurodol lar d ep o s i t r a t e i n London.i ~ r U.K. 90-day Treasu ry -Bi l l r a t e .

-Fore ign Exchange Rates :sp s p o t p r i c e o f pounds p e r d o l l a r .fw Forward p r i c e o f pounds p er d o l l a r .US/OM s p o t pr i ce o f d o l l a r s in te rms o f marks.OM/UK sp o t p r i c e o f marks i n te rms o f pounds .US/UK s p o t p r i c e o f d o l l a r s in te rms o f pounds.

-Bid-Ask Pr ices :Bid Pr ice a d e a l e r paid f o r a U.S. o r U.K. 90-day

Treasu ry -Bi l l a t purchase .Ask Pr ice the inves to r must pay t o th e d e a l e r fo r

th e U.S. o r U.K. 90-day Treasu ry -Bi l l .

A ll data are weekly, from Apr i l 3 t o December 24, 1992. The

i n t e r e s t r a t e s a re Fr iday c lo s in g f i g u r e s , c o l l e c t e d from Th e

Bank o f Englanq Quar t e r l y Bul l e t i n ; th e r e s t are c o l l e c t e d from

th e Friday e d i t i o n s o f Th e Wall S t r e e t Jo u rn a l .

V I. Methodo f

s t u d yA. Th e Po in t o f u s i n g Two S e t s o f S e c u r i t i e s

The method by which we wi l l accomplish a comparison o f t h e

opposing explanat ions involves us ing tw o p a i r s o f s e c u r i t i e s ,

def ined i n sec t ion V as a t r a d i t i o n a l and n o n - t r a d i t i o n a l p a i r .

Frenke l and Levich along wi th many o t h e r r e sea r ch e r s have used

t h i s t echn ique in t h e i r s t u d i e s .

A t e s t fo r i n t e r e s t p a r i t y r e q u i r e s t h a t th e s e c u r i t i e s used

t o ca l cu l a t e ClAMs be as s i m i l a r as p o s s i b l e . They shou ld be o f

th e same matur i ty and r i s k c l a s s t o produce a completely v a l i d

1 1


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t e s t . As th e d i scu ss io n on p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k

revealed , however, us ing the t r a d i t i o n a l p a i r o f s imple u.s. and

U.K. Treasury B i l l s in t roduces some e r r o r because o f t h e

d i f f e r e n t r i s k s asso c ia t ed with each. What we must do, t h en , i s

t o remove t h i s r i s k from th e c a l c u l a t i o n o f ClAMs.

One way t o accomplish t h i s i s to use a n o n - t r a d i t i o n a l

s e c u r i t i e s p a i r i n ad d i t io n t o th e t r a d i t i o n a l one j u s t

mentioned. The non- t rad i t i ona l p a i r i d e a l l y c o n s i s t s of da ta

co l lec ted a t an ex te rna l f i nanc i a l c e n t e r , such as P a r i s , on th e.r a t e s th e tw o cur renc ies command. Since such data was n o t

a v a i l a b l e f o r u se in t h i s s tudy, we c r e a t e a sUbs t i t u t e by bas ing

both s e c u r i t i e s in London in s tead o f some e x t e r n a l c e n t e r. I t i s

hoped t h a t t h i s w i l l serve th e funct ion o f eq u a l i z in g t h e

p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k adequate ly.

comparing th e ClAMs produced by t h e n o n - t r a d i t i o n a l a s wel l

as th e t r a d i t i o n a l p a i r should then r ev ea l t h a t margins a re

smal ler fo r non- t rad i t i ona l p a i r da ta . I f t r a n s a c t i o n s c o s t s

expla in away a l l th e margins produced by n o n - t r a d i t i o n a l p a i r

data b u t only p a r t of t hose as soc ia ted with t r a d i t i o n a l p a i r

da ta , we have evidence t h a t p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k i s

indeed an impor tan t co n s id e r a t io n i n e s t ab l i sh ing e f f e c t i v e

i n t e r e s t p a r i t y. I f i t should t u rn ou t , though, t h a t th e

t ransac t ions c o s t s a re s u f f i c i e n t in encompassing a l l margins

r egard les s o f which d a ta i s used, then we could conclude t h a t

tu rbulence does n o t a f f e c t i n t e r e s t p a r i t y equi l ib r ium much.

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B. c a l c u l a t i n g th e ClAMs

The covered i n t e r e s t a r b i t r a g e margins are c a l c u l a t e d us ing

th e f i r s t p a r t of equat ion ( l ) . The simple margins obta ined with

t r a d i t i o n a l p a i r data can be observed as an example from

Figure 3 .

C. Est imat ing th e Neut ra l Band

As t r ansac t ions cos t s a re imposs ible t o quan t i fy d i r e c t l y ,

we must use a prox ies fo r c o s t s in th e currency as wel l as

s e c u r i t i e s markets . Again, these prox ies are genera l ly accepted

and used in th e l i t e r a t u r e concerning CIAMs, and thus w i l l be

adopted d i r e c t l y .

The t r i a n g u l a r a r b i t r a g e equat ion (2 ) provides an i n d i r e c t

method fo r measuring t r ansac t ions cos t s .

({US/DM)*{DM/UK/{US/UK)=l (2)

( fo r va r i ab l e d e f i n i t i o n s , see sec t ion v .)

I t should not be poss ib le fo r th e holder o f d o l l a r s t o purchase

pounds through German marks and end up with a d i f f e r e n t amount

than i f they go d i r e c t l y from d o l l a r s t o pounds. Thus, in th e

absence o f t r ansac t ions c o s t s , equat ion (2 ) must equal 1 . When

th e cos t s o f t r ansac t ing in these markets i s f igured i n , t h e r e

w i l l r e s u l t a s l i g h t discrepancy i n th e condi t ion . This

discrepancy i s our proxy fo r t r ansac t ions cos t s in currency

markets .

In us ing equat ion (2 ) t o r ev ea l t r ansac t ions c o s t s , we a re

assuming t h a t currency markets a re e f f i c i e n t . I t i s very easy fo r

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16/27

banks an d t r a d e r s t o take advantage o f any earnings p o te n t i a l

der ived from t r i a n g u l a r a r b i t r a g e without even t y ing up funds .

Thus, i t i s wel l wi th in reason fo r t he sake of t he proxy t o

assume e f f i c i e n c y i n nUl l i fy ing such oppor tun i t i e s .

I t i s important t h a t the da ta co l l ec t ed be as s imul taneously

recorded a s poss ib l e . Exchange r a t e s a re in a cont inuous s t a t e of

f lux due t o 24 hour t r ad ing , and c lea r ly observat ions c o l l e c t e d

a t d i f f e r e n t po in t s i n t ime cause unnecessary noise t o be

in t roduced .

Since i t was n o t poss ib le t o f ind a l l t h ree c ross r a t e s

required to compute equat ion (2)' i n t he forward exchange markets ,

i t i s assumed t h a t t r ansac t ions cos t s i n forward markets a re

equal t o those of t he sp o t markets . In o the r words, in terms o f

equat ion (1 ) , tf, ,=t. p

To f ind a proxy fo r t r a n sa c t i o n s c o s t s in s e c u r i t i e s

markets , th e fol lowing i s used:

(Ask Pr ice-Bid Price) / (Ask Pr ice) (3 )

Dealers o f s e c u r i t i e s requi re compensation, th e d i f f e r e n c e

between the b id and ask p r i c e , fo r t h e i r se rv i ces and l i q u i d i t y .

Following th e work o f Demsetz (1968), Frenke l and Levich mul t ip ly

the reSUl t ing f igure by 2 .5 t o es t imate t o t a l c o s t s i n s e c u r i t i e s

markets . In t h i s way the proxy i s then extended t o account fo r

brokerage fees as wel l as th e reward dea l e r s command. The method

w i l l thus be used fo r our purposes as wel l .

Again, th e spreads were no t r ead i ly ava i l ab le fo r B r i t i s h

s e c u r i t i e s , so we assume tdOlll=tror.

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Figure 4 disp lays , among other th ings , the p l o t o f a f ive

week moving average of computed t r ansac t ions cos t s . The moving

average was u t i l i z e d to smooth ou t excessive v o l a t i l i t y from th e

measurement. Figure 5, on th e o the r hand, shows th e average

t r ansac t ions cos t from over th e e n t i r e per iod o f s tudy p lo t ted as

a neu t r a l band around i n t e r e s t p a r i t y. Our average es t imate o f

the t r ansac t ions costs l an d s around 0.10%, which i s a reasonab le

f igure when compared t o th e f indings of Branson, Holmes, and

Scho t t .

VI I I . Resul ts

The overa l l r e s u l t s o f computing ClAMs and t r a n sa c t i o n s

cos t s are seen in f u l l in Figure 4 and Figure 5.

From FigUre 4, the most immediately s t r i k i n g observat ion i s

t h a t th e margins genera ted by th e non- t r ad i t iona l p a i r a re

without excep t ion g r e a t e r than th e t r a d i t i o n a l p a i r margins . This

runs con t ra ry t o e x p e c t a t i o n s - - r e c a l l t h a t by equal iz ing

p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k i t was expected t h a t t h e r e e x i s t

l e s s discrepancy between th e i n t e r e s t r a t e s an d between London

an d New York. Thus, the margins were a lso expected t o be sma l l e r.

What t h i s leads us to be l i eve , then , i s t h a t ou r non

t r a d i t i o n a l p a i r data i s no t an adequate subs t i t u t e fo r the i d e a l

type mentioned e a r l i e r . I t was hoped t h a t basing bo th s e c u r i t i e s

in London would do the job . However, the London T- Bi l l and

Eurodol la r deposi t s may no t be completely comparable . There must

e x i s t some fundamental di ff e rence between these tw o types o f

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i n t e r e s t r a t e s t h a t render them inadequate fo r the purpose of ou r

s tudy. I f Eurodol la r data in Par i s fo r both cu r renc i e s had been

found, t h ey would have most l i k e l y produced margins smal le r than

those of the t r a d i t i o n a l p a i r .

The margins crea ted by th e t r a d i t i o n a l p a i r data a re almost

completely bound by t r ansac t ions c o s t s , i . e . th e n e u t r a l band.

This observat ion i s made c l e a r by looking a t Figure 5. Here, t h e

average t o t a l t r ansac t ions cos t s through th e e n t i r e t ime per iod

i s found and then p lo t ted around i n t e r e s t p a r i t y , producing a

neu t ra l band. This neu t ra l band con ta ins w i th in i t a l l excep t one

t r a d i t i o n a l p a i r ClAM. Recal l t h a t any po in t with in th e n e u t r a l

band i s no t a p r o f i t oppor tuni ty as c o s t s outweigh b e n e f i t s .

The only poin t in our sample t ime per iod t h a t d id no t f a l l

with in th e neu t ra l band occurred on September 18, very c lo se t o

the t ime Br i t a i n l e t i t s currency f l o a t . There a re two poss ib l e

ways of in te rp re t ing t h i s o u t l i n e . F i r s t , i t could be t h a t a r e a l

ClAM, and thus an unexplo i ted p r o f i t oppor tuni ty, ex i s t ed a t t h i s

t ime. In f a c t , a p r o f i t oppor tuni ty could have pe r s i s t ed fo r

near ly two weeks around September 18 and we would no t know about

i t because of t he spa rs i ty of observat ions . Thus i t could be t h a t

th e v o l a t i l i t y surrounding B r i t a i n ' s e x i t from th e ERM d id r e a l l y

cause margins , giv ing suppor t fo r Grubel ' s theory.

However, th e September 18 po in t could merely r e f l e c t t imingproblems in the da ta . The exchange r a t e s moved quickly dur ing

t h i s per iod and the d i f f e r e n t measures t h a t go in to ca lcu la t ing

ClAMs a re n o t co l l ec ted a t exact ly the same poin t in t im e . Thus,

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19/27

add i t i ona l noise crea ted by th e moves could be causing an

i n f l a t e d margin. The margin observed could then be j u s t a r e s u l t

o f measurement imper fec t ions . Unt i l more condensed ( fo r example

dai ly) data a re found and t e s t e d t o reduce the t iming problem, i t

cannot be cla imed with c e r t a in ty t h a t t r a n sa c t i o n s c o s t s negated

a l l p r o f i t oppor tun i t i e s fo r th e per iod of stUdy.

IX . Conclus ions

The major weakness o f t h i s s tudy was th e q u a l i t y of da ta and

th e lack of t r u e ex te rna l cen t e r da ta . I f we had obta ined say

da i ly observa t ions , i t would have been much e a s i e r t o make a

c l e a r judgement on what th e case of September 18 r e a l l y

rep re sen t s . Also, r e a l ex te rna l cen t e r da ta fo r th e non-

t r a d i t i o n a l p a i r would have aided in explor ing

p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k with more c l a r i t y.

s t i l l , th e r e s u l t s discussed above were succes s fu l i n

showing t h a t fo r most o f th e t ime, t r ansac t ions c o s t s a re

s u f f i c i e n t in expla in ing away margins. Regardless of t he one

anomaly, th e r e s u l t s do tend to lead us toward concluding t h a t

i n t e r e s t p a r i t y i s maintained between London and New York la rge ly

by t r ansac t ions cos t s a lone , and t h a t p o l i t i c a l / fi n a n c i a l - c e n t e r

r i s k cons ide ra t ions a re of secondary importance. This i s not t o

say t h a t th e theory p resen ted by Grubel i s not app l i cab l e andshould be abandoned, b u t t h a t t r ansac t ions c o s t s c l e a r l y proved

to be th e dominant force i n es t ab l i sh ing e ff e c t i v e i n t e r e s t

p a r i t y in our study.

17


20/27

Th e f a c t t h a t t r a n s a c t i o n s cos t s appeared t o do th e jo b

alone probably stems from th e f a c t t h a t both o f t h e f i n a n c i a l

cen t e r s i n ques t ion are known fo r t h e i r o v e r a l l s t a b i l i t y . Even

though London was exper iencing major tu rbu lence , Br i t a i n i s s t i l lan economical ly s t ro n g and p o l i t i c a l l y s t a b l e i nves tmen t s i t e .

Thus inves to r s a re l e s s l i k e l y to respond nega t ive ly t o adverse

news because they have assurances o f sa f e t y based on t h e

h i s t o r i c a l t r a c k record of London.

Thus i t cou ld be t h a t th e p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k

cons ide ra t ion i s o f much g r e a t e r importance when consider ing

o the r f i nanc i a l cen t e r s . Were we to co n s id e r covered i n t e r e s t

a r b i t r a g e between cen te r s l i k e New York and Kuala Lumpur o r

London and Prague, p o l i t i c a l / f i n a n c i a l - c e n t e r r i s k might a s s e r t

i t s e l f as being o f major importance i n e s t a b l i sh i n g i n t e r e s t

p a r i t y because o f th e d i f f e r e n t i a l i n r i s k c l a s s between th e

cen te r s in quest ion . This p o s s i b i l i t y presen t s an i n t e r e s t i n g '

area , fo r f u r t h e r r esea rch .

1 8


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J'igure 1

Interest Parity

0 . 5 % . . . , . . . . . . - - - - - - - - - - - - - - - - - - - - , - - - - - - - - : > 1 ... .........

...............

...

'

. ..'O . O % + - - - - - - - - - - - - - - - - - . ~,,;...- - - - - I...'- ..................

'*.............-

d; ; -0.5% ..............~

.'...............i5&en -1.0% . / / , / /(J)(J)

.........

...

~

.' ... , .....

.........

.'1.5%......

..........

..'.'

...........

. - 2 . 0 % o o : . - - - - . . . . . , . . - - - - r - - , - - - . . . , . . . . . - - - - - - f - - - - - - - i

-2.0% -1.5% -1.0% -0.5% 0.0% 0.5%Premium/Discount (%)

19
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22/27

Jligure 2

Interest ParityWith Neutral Band

0 . 5 % , . . . - - - - - - - - - - - - - - - - - r - - - - - ~ - - - :

--'tS~

cQ)~ Q)

:t=Q.....CJ)Q)~ Q).....c

0.5%.0%1.0% -0.5%

0.0%

-0.5%

-1.0%

-1.5%

Premium/Discount (%)

2 0


23/27

I ' i qu re 3

Traditional Pair ClAMs0 . 4 % . . . . , . . . . . - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - .

0.3% - - - - - _ - ..- - -............. . - - -. _ _ - - - -

0.2% - - ..- -- ..- - - ..- - -.-- _ -.- -.......... . - - - _ - _ - ..

.. 0.1% - ..- - - . - ....-----,-----11.--fiioQ).. 0 . 0 % - + - - - - T + - - ~ - : - - + - - - - ' - - - - - - - - - - - - - - _ T _ - - -

-0.1% - .. - - - . - - - - . - - ----- - - -- - - . - - - . - - ..- - - - - - - - .

-0.2% - - - - - ..- . - - - - - - - - - - - - . - - - - ..- - . -

-0.3% . . . . . - r- "T""""" I "" ' " "T"- r- . - r - - r. .. . . . , . . -r -o r-o . . . . . . , .. - r - "T""""" r- -T- - r- . - r -T. . . .. . , . . - r -T""" ' "1- - -r- r- "T""""" r- - r- - r- - r-T"" ' " " I r-T"- r- .- r - 'Apr3",17 May1 1 ~ 29 12 28 10 24 Aug7 21 Sep4 18 Oct2 18 30 13 27 11 2410 24 8 22 J u n ~ 19 Jul3 17 31 14 28 11 2 ~ 9 23 Nove 20 Dec4 18

1-- Trad. Pair 1

21


24/27

J'iqure "

ClAMs and Transactions Costs0 . 4 % . . . , . . . - - - - - - - - - - - - - - ' - - - - - - - - - - - - - - - - - - - . . . ,

i\._ __ __ _ _ _ . __ - _.._. __ .._ .. _ __ _-_ .. __ ._ _ _.- i 4__ ... _ . _ . _ . _ ......... _ . .. _._._ - .0.3% I \

I I

II \,0.2%

C 0.1%Q)

oCDQ..

0.1%

0.2%

0 . 0 % + - - - - ~ - - ~ ~ - . . . . . . : . . - - - . . . . . : . . . . - - . . : . . . - . . - - - - - - . . . . . : . . . . - T -

0 . 3 % - J . . r - r - . . , . - r - - T - - r - ~ T - T - - r . , . - ' T " ' " " 1 r - - r - r - . . , . - r - - r - - r - - . - . , . . - , - - r . , . - ' T " ' " " 1 r - - r - r - ~ T -

Apr3 17 May1 1 ~ 29 12 28 10 24 AU1il7 21 Sep4 18 Oct2 18 30 13 27 11 24-to 24 8 22 J u n ~ 19 Jul3 17 31 14 28 11 2 ~ 9 23 Nove 20 Dec4 18

-"- Trad. Pa,ir -_._. Non-Trad. Pair - Mov-Ave of T-costs

22
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25/27

O . O % - t - - - - - - - - - - - - - - . . . . . . , . . . : ~ ~ ~ -

J l iqure 5

Computed Neutral BandWith Traditional Pair ClAMs0 . 5 % - r - - - - - - - - - - - - - - - - - - - r - - ~ . . . . . . ,

- 16

~ -0.5%L -

~ Q

.....-1.0%

m-

a>.....

c

-1.5%

-2.0% /-2.0% -1.5% -1.0% -0.5% 0.0% 0.5%

Premium/Discount (%)

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Bibl iography

Bank of England Quar te r ly Bu l l e t i n . November 1992. Pg 382.

Branson, William H. "The Minimum Covered I n t e r e s t D iff e r e n t i a l

Needed fo r In te rna t iona l Arbi t rage A c t i v i t y. " Journa l o fP o l i t i c a l Economy. Vol 77, no 6, 1969. Pg 1028.

Deardorff , Alan V. "One-Way Arbi t rage an d i t s Impl ica t ions fo rth e Foreign Exchange Markets ." Jo u rn a l of P o l i t i c a lEconomy. Vol 86, no 21, 1979. Pg 351.

Demsetz, Harold . "The Cost of Transact ing ." Quar ter ly Jo u rn a lof Economics. Vol 82, no 1, 1968. Pg 33.

Eiteman, David, and Arthur S t o n e h i l l , an d Michael Moffet t .Mul t ina t iona l Business Finance. Addison-Wesley Publ ish ingC o m p a n y ~ Reading: 1992.

Frenkel , Jacob A., and Richard M. Levich. "Transac t ion Costs andI n t e r e s t Arbi t rage : Tranqui l versus Turbulent Per iods . "Journal of P o l i t i c a l Economy. Vo l 85, no 6, 1977. Pg 1209.

- - - - - - . "Covered I n t e r e s t Arb i t r ag e : Unexploi ted P r o f i t s ? "Journal of P o l i t i c a l Economy. Vol 83, no 2, 1975. Pg 325.

Frenkel , Jacob A. " E l a s t i c i t i e s and I n t e r e s t Par i ty Theory."Journa l of P o l i t i c a l Economy. Vol 81, no 3, 1973. Pg 741.

Frenkel , Jacob A., and Michael Mussa. "The Eff ic iency ofForeign Exchange Markets and Measures of Turbulence"

American Economic Review. Vol 70, no 3. Pg 374.

Grubel , Herber t G. Forward Exchange, Sp ecu la t io n , and th eI n t e r n a t i o n a l Flow of Cap i t a l . Stanford , CA.: StanfordUnivers i ty Press , 1966.

Keynes, J.M. A Trac t on Monetary Reform. Macmil l ian , London:1971.

Madura, J e f f . In te rna t iona l Financ ia l Management. West Publ ish ingCompany, s t . Pau l : 1989.

Prachowny, Mart in F. J ."A

Note onI n t e r e s t

p a r i t y and th e Supplyo f Arb i t r ag e Funds." Jo u rn a l o f P o l i t i c a l Economy. Vol 78,no 3, 1970. Pg. 741.

Riv e ra -Ba t i z , Francisco , and Luis Rivera-Bat iz . I n t e r n a t i o n a lFinance and Open Economy Macroeconomics. Macmil l ianPubl ish ing Company, New York: 1994.

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Salva tore , Dominick. In te rna t iona l Economics. MacmillianPubl ish ing Company, New York: 1990.

Sohmen, Egon. The Theory of Forward Exchange. Princeton, NJ:Princeton Univers i ty Press , 1966.

The Wall s t r e e t Journa l . Various Issues

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An Empirical Study of Covered Interest Arbitrage_ Marqins Durinq

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