Modeling Covered Interest Parity Deviations - A Structural VAR Approach
19 Pages Posted: 27 Sep 2011 Last revised: 26 Sep 2012
Date Written: September 2012
The paper develops a simple model to explain Covered Interest Parity (CIP) deviations. The model allows for a time-varying country risk premium and is used to motivate a Structural Vector Auto-Regression (SVAR) approach to study the joint dynamics of the Covered Interest Differential (CID) and the Forward Premium (FP). Three independent, structural shocks are postulated – a country risk premium shock, an inflation rate differential shock and a forward market shock. Long run restrictions are imposed to enable identification of the parameters relating the structural shocks to the reduced form shocks. The main contributions are as follows. (1) The paper develops a methodology to relate movements in the VAR endogenous variables to a larger number of structural shocks than the number of endogenous variables. (2) The paper proposes this SVAR methodology as a way to test CIP on a risk-adjusted basis. The identifying restrictions are motivated by the theoretical model mentioned earlier. The SVAR methodology allows one to relate movements in CID and FP to underlying structural shocks and provides information regarding the speed of market response to these shocks. In the process, the methodology sheds light on why CIP does not hold. (3) The paper makes an empirical contribution by applying this methodology to study financial integration between Indian and US markets at the short end of the curve.
Keywords: Covered Interest Parity, Structural VAR, India
JEL Classification: F36, G15, C32
Suggested Citation: Suggested Citation