DOES INTEREST PARITY THEORY HOLD IN SINGAPORE

Abstract

This academic exercise presents some empirical evidence on the interest parity theory and also discusses some possible explanations for the deviation from this theory. The importance of this theory lies in the fact that if it fails, then there exists arbitrage profit opportunities which allow funds to move across countries. In the traditional financial theory, arbitrage profit opportunities always provide important results. For instance, the Arbitrage Pricing Theory (APT), used in determining whether a stock price is over/under-priced, and the Option Pricing Theory (Put-Call parity), used to approximate the price of call and put options, both of which adopt the idea of arbitrage profit opportunities. The results in this academic exercise show that although arbitrage profit opportunities do exist even when transaction costs are taken into consideration, it does not benefit the investors to engage in covered interest arbitrage activities. This is because the profits that can be obtained is of very low margin. Furthermore, our test results also show that speculation is not an important factor for determining the forward rate under the current exchange rate regime. Consequently, the deviation of the interest parity theory should be due mainly to transaction costs rather than speculative activities.