Interest Rate Parity

1) In the attempt to test whether the interest rate parity is held or not in the real world, we treat the Interbank Exchange Rate as an explanatory variable and the forward exchange rate premium as dependent variable.

From our analysis we found that the main players in the foreign exchange market are financial institutions since their trading volume accounts a high proportion of the total market. These financial institutions may hold limited cash deposit in their accounts; they can borrow from other banks that have excess of cash in order to finance their purchases of currencies. The rate banks use is the Interbank rate and therefore we would perform the most accurate calculation by using Interbank rate as an explanatory variable into our regression model and test whether the interest rate parity is held or not. Therefore, in this report, we look at financial institution point of view.

Another theory we take into account is the purchasing power parity (PPP) that is also used to determine the forward rate premium. Inflation rates differential between 2 countries are used as explanatory variable to find the dependent variable.

Core inflation is most preferred in order to determine the exact result because the volatility of the prices of commodities and petroleum will result in lots of fluctuation of the tests. However, China and India historical core inflation data is not available so we treat normal inflation data from both countries as the explanatory variable.

2) As we have discussed in prior question that the explanatory variables will be the plug-in independent variables in the construction of regression models;