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Interest parity, cointegration, and the term structure: Testing in an integrated framework

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  • Georgoutsos, Dimitris A.
  • Kouretas, Georgios P.

Abstract

In this paper, we develop a methodology for testing jointly the validity of the expectations hypothesis of the term structure (EHTS) and the uncovered interest rate parity (UIRP) within the framework provided by cointegration theory. For this purpose, we use data on interest rates from the U.S. dollar-Libor, GBP-Libor, and Euro-Libor markets with maturities ranging from 7days to 12months. The main findings of our analysis are as follows: (i) we fail to find the correct rank of the cointegration space suggested by our methodology; (ii) with the application of tests for parameter stability in cointegrated models, we show that our cointegration results are sample independent and that the estimated coefficients do not suffer from instabilities in recursive estimations; (iii) from the moving average representation of the model, we estimate the common stochastic trends whose components establish, in the USD/Euro case, the interdependence of interest rates in the formation of the driving forces of the system; (iv) we manage to identify with the two theories a sub-space of the estimated cointegration space.

Suggested Citation

  • Georgoutsos, Dimitris A. & Kouretas, Georgios P., 2016. "Interest parity, cointegration, and the term structure: Testing in an integrated framework," International Review of Financial Analysis, Elsevier, vol. 46(C), pages 281-294.
    • Handle: RePEc:eee:finana:v:46:y:2016:i:c:p:281-294
    DOI: 10.1016/j.irfa.2015.12.001
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    Cited by:

    1. Giovanni Verga & Federica Trani & Nicoleta Vasilcovschi, 2018. "The Interaction between American and European IRS Interest Rates," Scientific Annals of Economics and Business (continues Analele Stiintifice), Alexandru Ioan Cuza University, Faculty of Economics and Business Administration, vol. 65(1), pages 81-96, March.

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    More about this item

    Keywords

    Cointegration; Expectations theory; Uncovered interest parity; Eurocurrency markets; Temporal stability;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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