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Why exchange rate pass-through matters in forward exchange markets

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  • Choi, Yoonho
  • Choi, E. Kwan

Abstract

Persistent deviations from a covered interest rate parity (CIRP) have been observed between the United States (US) and the United Kingdom (UK) from January 2002 to August 2020. This study argues that the CIRP does not hold because even if income from domestic and foreign investments is equalized, foreign investment's utility could be higher than that of domestic investment depending on the exchange rate pass-through (ERPT) into import price. Theoretically, the deviations of observed forward exchange rates from CIRP conditions are attributed to changes in importable goods prices and ERPT. A change in net capital flow affects import price volatilities and deviations from the CIRP. Therefore, the forward exchange rate depends not only on the interest rate differential between countries but also on ERPT into the import price. Using a logarithmic utility function, this study derives a utility-equalizing forward rate (UEFR). An increase in net capital outflow and the ERPT into the import price reduces the UEFR. Our empirical evidence shows that from December 2011 to June 2020, the UEFR estimates trace the actual US−UK forward exchange rates better than CIRP.

Suggested Citation

  • Choi, Yoonho & Choi, E. Kwan, 2022. "Why exchange rate pass-through matters in forward exchange markets," Economic Modelling, Elsevier, vol. 110(C).
    • Handle: RePEc:eee:ecmode:v:110:y:2022:i:c:s0264999322000414
    DOI: 10.1016/j.econmod.2022.105795
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    More about this item

    Keywords

    Covered interest rate parity; Utility-equalizing forward rate; Exchange rate pass-through;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications

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