An Empirical Test of the Interest Rate Parity: Does It Hold Between U.S.A and Selected Emerging Asian Economies‪?‬

INTRODUCTION The theory of Interest Rate Parity (IRP) holds that one cannot make arbitrage profits due to different interest rates in different countries. Any gain made because of interest rate differentials will be wiped out due to adjustment in the exchange rate at the end of the investment time horizon. Let us assume that the three month interest rate in the U.S.A. is 11 percent and the same three month interest rate in the U.K. is 7 percent. This would indicate that investors in the U.K. will transfer their funds to the United States to take advantage of the higher interest rates and to earn a higher return. However, the theory of interest rate parity holds that such arbitrage opportunity is not possible because after three months the U.S. dollar is expected to depreciate by approximately 4 percent. Therefore, the British investor will not be any better off at the end of three months because the 4 percent higher return in the U.S. will be wiped out when the dollar declines by 4 percent at the end of three months when the British investor converts the dollar for British pounds. This is an exchange rate risk. Exchange rate risk can be covered by selling the expected dollar value to be received after a three month investment period in the forward market. Therefore to gain from a covered interest arbitrage, a British investor must simultaneously buy dollars in the spot market and sell dollars in the forward market. This will increase the value of the dollar in the spot market and depreciate the value of the dollar in the forward market until equilibrium is reached and wipes out any arbitrage profit. Therefore, whether the investor invests in the U.K. or U.S.A., they should get the same return. This study does an empirical test to see if interest rate parity holds between the U.S.A. and emerging economies of Asia like Malaysia, Singapore, Thailand, Korea, India, Pakistan and Philippines.