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July/August 1989, 
Vol. 71, No. 4
Posted 1989-07-01

Tests of Covered Interest Rate Parity

Daniel L. Thornton investigates whether “covered interest parity” holds on average. Covered interest parity implies a certain linear relationship between domestic and foreign interest rates (for assets of a given maturity and risk) and spot and forward exchange rates, and is assumed to hold in many open-economy macroeconomic models. The author points out that, while previous tests have relied on the markets’ reactions to specific news (usually money announcements), there is a more general test that can be applied to all observed exchange rate data, not simply data around the times when specific news is released. Thornton applies this test, as well as the usual test of market reactions to money announcements, to daily data for the United States, Canada, Switzerland, Germany, France, the United Kingdom, and Japan for the period from October 5, 1979 through September 14, 1988. His results are consistent with the hypothesis that covered interest parity holds on average over this period.