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One-Way Arbitrage-Based Interest Parity: An Application of the Fletcher-Taylor Approach in Short-Date Markets

This study is motivated by two major considerations. First, the Fletcher and Taylor (1996) approach has yet to be applied to short-date markets to assess the diminishing role of transaction costs in explaining the deviations of observed forward foreign exchange prices from interest parity forward prices. Second, the role of transaction costs in one-way arbitrage-based interest parity has not been examined. Applying the Fletcher and Taylor approach to one-way arbitrage-based interest parity in short-date capital markets, we document three major findings: (i) a narrower neutral band around interest parity line, as implied by one-way arbitrage, does not diminish the role of transaction costs; (ii) the variances of the estimated deviations are a decreasing function of the time spent outside the transactions cost band; and (iii) the magnitude of arbitrage profits tends to be small and economically insignificant though profitable opportunities are not rare in the short-date markets studied.