IDEAS home Printed from https://ideas.repec.org/a/bok/journl/v14y2008i3p133-155.html
   My bibliography  Save this article

Interest Arbitrage and Interest Rates in Korea

Author

Listed:
  • Byoung Hark Yoo

    (The Bank of Korea)

Abstract

The Bank of Korea has raised its policy rate by 1.75 %p since mid-2005 but yields on 3-year government bonds increased by just 1%p for the same period. Some argue that interest arbitrage, which happened when the covered interest rate parity condition was broken in 2006 and 2007, increased the demand for Korean bonds and, as a result, decreased interest rates. We set up a small open DSGE model and estimate it using Bayesian methods to see whether the argument is right. The estimation results show that a decrease in the risk premium in the foreign exchange market, which is a necessary condition for interest arbitrage, is significantly associated with a fall in interest rates. In addition, the link between the foreign exchange market and the domestic bond market has been more strengthened since the Asian currency crisis.

Suggested Citation

  • Byoung Hark Yoo, 2008. "Interest Arbitrage and Interest Rates in Korea," Economic Analysis (Quarterly), Economic Research Institute, Bank of Korea, vol. 14(3), pages 133-155, September.
    • Handle: RePEc:bok:journl:v:14:y:2008:i:3:p:133-155
    as

    Download full text from publisher

    File URL: http://imer.bok.or.kr/attach/imer_kor/2545/2013/12/1386569387436.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Schmitt-Grohe, Stephanie & Uribe, Martin, 2003. "Closing small open economy models," Journal of International Economics, Elsevier, vol. 61(1), pages 163-185, October.
    2. Rhee, S Ghon & Chang, Rosita P, 1992. "Intra-day Arbitrage Opportunities in Foreign Exchange and Eurocurrency Markets," Journal of Finance, American Finance Association, vol. 47(1), pages 363-379, March.
    3. Tommaso Monacelli, 2003. "Monetary Policy in a Low Pass-Through Environment," Working Papers 228, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    4. Lubik, Thomas A. & Schorfheide, Frank, 2007. "Do central banks respond to exchange rate movements? A structural investigation," Journal of Monetary Economics, Elsevier, vol. 54(4), pages 1069-1087, May.
    5. Ali Dib, 2011. "Monetary Policy in Estimated Models of Small Open and Closed Economies," Open Economies Review, Springer, vol. 22(5), pages 769-796, November.
    6. Obstfeld,Maurice & Taylor,Alan M., 2005. "Global Capital Markets," Cambridge Books, Cambridge University Press, number 9780521671798, November.
    7. Popper, Helen, 1993. "Long-term covered interest parity: evidence from currency swaps," Journal of International Money and Finance, Elsevier, vol. 12(4), pages 439-448, August.
    8. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    9. Nooman Rebei & Steven Ambler & Ali Dib, 2004. "Optimal Taylor Rules in an Estimated Model of a Small Open Economy," Econometric Society 2004 North American Summer Meetings 627, Econometric Society.
    10. Mark E. Wohar & Nathan S. Balke, 1998. "Nonlinear dynamics and covered interest rate parity," Empirical Economics, Springer, vol. 23(4), pages 535-559.
    11. Jordi Galí & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 72(3), pages 707-734.
    12. Best, Gabriela, 2013. "Fear of floating or monetary policy as usual? A structural analysis of Mexico's monetary policy," The North American Journal of Economics and Finance, Elsevier, vol. 24(C), pages 45-62.
    13. Lawrence J. Christiano & Roberto Motto & Massimo Rostagno, 2003. "The Great Depression and the Friedman-Schwartz hypothesis," Proceedings, Federal Reserve Bank of Cleveland, pages 1119-1215.
    14. Frenkel, Jacob A & Levich, Richard M, 1975. "Covered Interest Arbitrage: Unexploited Profits?," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 325-338, April.
    15. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-660, June.
    16. Thomas Lubik & Frank Schorfheide, 2006. "A Bayesian Look at New Open Economy Macroeconomics," NBER Chapters, in: NBER Macroeconomics Annual 2005, Volume 20, pages 313-382, National Bureau of Economic Research, Inc.
    17. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Closed versus Open Economies: An Integrated Approach," NBER Working Papers 8604, National Bureau of Economic Research, Inc.
    18. Benigno, Pierpaolo & Benigno, Gianluca, 2002. "Implementing Monetary Cooperation Through Inflation Targeting," CEPR Discussion Papers 3226, C.E.P.R. Discussion Papers.
    19. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    20. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
    21. Peel, David A & Taylor, Mark P, 2002. "Covered Interest Rate Arbitrage in the Interwar Period and the Keynes-Einzig Conjecture," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(1), pages 51-75, February.
    22. Mr. Alejandro Justiniano Espigares & Mr. Selim A Elekdag & Mr. Ivan Tchakarov, 2005. "An Estimated Small Open Economy Model of the Financial Accelerator," IMF Working Papers 2005/044, International Monetary Fund.
    23. Clinton, Kevin, 1988. "Transactions Costs and Covered Interest Arbitrage: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 358-370, April.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Leith, Campbell & Wren-Lewis, Simon, 2009. "Taylor rules in the open economy," European Economic Review, Elsevier, vol. 53(8), pages 971-995, November.
    2. Caraiani, Petre, 2008. "An Analysis Of Domestic And External Shocks On Romanian Economy Using A Dsge Model," Journal for Economic Forecasting, Institute for Economic Forecasting, vol. 5(3), pages 100-114, September.
    3. Thomas Lubik & Frank Schorfheide, 2006. "A Bayesian Look at New Open Economy Macroeconomics," NBER Chapters, in: NBER Macroeconomics Annual 2005, Volume 20, pages 313-382, National Bureau of Economic Research, Inc.
    4. Alejandro Justiniano & Bruce Preston, 2010. "Monetary policy and uncertainty in an empirical small open‐economy model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 25(1), pages 93-128, January.
    5. Massimiliano Marcellino & Yuliya Rychalovska, 2012. "An estimated DSGE model of a Small Open Economy within the Monetary Union: Forecasting and Structural Analysis," RSCAS Working Papers 2012/34, European University Institute.
    6. Pasricha, Gurnain, 2007. "Financial Integration in Emerging Market Economies," MPRA Paper 5278, University Library of Munich, Germany.
    7. De Paoli, Bianca, 2009. "Monetary policy and welfare in a small open economy," Journal of International Economics, Elsevier, vol. 77(1), pages 11-22, February.
    8. Justiniano, Alejandro & Preston, Bruce, 2010. "Can structural small open-economy models account for the influence of foreign disturbances?," Journal of International Economics, Elsevier, vol. 81(1), pages 61-74, May.
    9. Ali Dib, 2011. "Monetary Policy in Estimated Models of Small Open and Closed Economies," Open Economies Review, Springer, vol. 22(5), pages 769-796, November.
    10. Massimiliano Marcellino & Yuliya Rychalovska, 2014. "Forecasting with a DSGE Model of a Small Open Economy within the Monetary Union," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 33(5), pages 315-338, August.
    11. Adnan Haider Bukhari & Safdar Ullah Khan, 2008. "A Small Open Economy DSGE Model for Pakistan," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 47(4), pages 963-1008.
    12. Tatiana Kirsanova & Stephanus le Roux, 2013. "Commitment vs. Discretion in the UK: An Empirical Investigation of the Monetary and Fiscal Policy Regime," International Journal of Central Banking, International Journal of Central Banking, vol. 9(4), pages 99-152, December.
    13. Wieland, Volker & Cwik, Tobias & Müller, Gernot J. & Schmidt, Sebastian & Wolters, Maik, 2012. "A new comparative approach to macroeconomic modeling and policy analysis," Journal of Economic Behavior & Organization, Elsevier, vol. 83(3), pages 523-541.
    14. García, Carlos J. & González, Wildo D., 2013. "Exchange rate intervention in small open economies: The role of risk premium and commodity price shocks," International Review of Economics & Finance, Elsevier, vol. 25(C), pages 424-447.
    15. Carlos Garcia & Wildo Gonzalez, 2014. "Why does monetary policy respond to the real exchange rate in small open economies? A Bayesian perspective," Empirical Economics, Springer, vol. 46(3), pages 789-825, May.
    16. Alexander Rathke & Tobias Straumann & Ulrich Woitek, 2017. "OVERVALUED: SWEDISH MONETARY POLICY IN THE 1930s," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 58(4), pages 1355-1369, November.
    17. Funke, Michael & Paetz, Michael & Pytlarczyk, Ernest, 2011. "Stock market wealth effects in an estimated DSGE model for Hong Kong," Economic Modelling, Elsevier, vol. 28(1), pages 316-334.
    18. Tommaso Monacelli, 2003. "Commitment, Discretion and Fixed Exchange Rates in an Open Economy," Working Papers 233, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
    19. Thorvardur Tjörvi Ólafsson, 2006. "The New Keynesian Phillips Curve: In Search of Improvements and Adaptation to the Open Economy," Economics wp31_tjorvi, Department of Economics, Central bank of Iceland.
    20. Mr Steinbach & Pt Mathuloe & Bw Smit, 2009. "An Open Economy New Keynesian Dsge Model Of The South African Economy," South African Journal of Economics, Economic Society of South Africa, vol. 77(2), pages 207-227, June.

    More about this item

    Keywords

    Small Open DSGE model; Interest Arbitrage; Risk Premium; Interest Rates;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bok:journl:v:14:y:2008:i:3:p:133-155. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Economic Research Institute (email available below). General contact details of provider: https://edirc.repec.org/data/imbokkr.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.