MSc Finance Dissertation: Deviation from Covered Interest Rate Parity

This dissertation investigates deviations from Covered Interest Rate Parity (CIRP) in Hong Kong, exploring factors contributing to the gap between swap rates and interest rate differentials. It begins with a literature review, examining previous studies on CIP changes, the impact of foreign exchange liquidity, and the validity of CIP in Hong Kong. The research employs a quantitative approach, utilizing statistical analysis such as regression and Vector Auto-regression models to analyze currency prices, interest rates, and spot exchange rates of USD and HKD. The study finds that the condition of covered interest parity is not as good as the deteriorated position of CIP has witnessed by all the users. The dissertation concludes by discussing the theoretical and practical implications of the findings, acknowledging the limitations of the research, and reflecting on the lessons learned during the research process.

DISSERTATION
(DEVIATION FROM COVERED
INTEREST RATE PARITY IN
HONGKONG)

TABLE OF CONTENTS
cHAPTER 1 INTRODUCTION................................................................................................1
CHAPTER 2 LITERATURE REVIEW AND THEORY.........................................................3
2.1 Literature Review.............................................................................................................3
2.1.1. Changes take places in the covered interest parity in Hong Kong...........................3
2.1.2 Factors that causes differences between swap rate and interest rate in Hong Kong. 5
2.1.3 To tests the validity of the covered interest parity in Hong-Kong.............................7
2.1.4 Impact of foreign exchange liquidity conditions of bank on Covered interest parity9
2.2 Theoretical framework...................................................................................................12
CHAPTER 3 DATA AND METHODS..................................................................................14
3.1 Research methodology...................................................................................................14
3.2 Research approach..........................................................................................................15
3.3 Research design..............................................................................................................15
3.4 Research method............................................................................................................17
3.5 Data collection................................................................................................................17
3.6 Ethical considerations.....................................................................................................17
CHAPTER 4 ANALYSIS AND RESULTS............................................................................18
4.1 Descriptive statistics.......................................................................................................18
4.2 USDHKD Interest rates analysis using regression.........................................................73
4.3 Spot exchange rates........................................................................................................77
4.5 Regression among spot exchange and USD and HKD values.......................................81
Vector Auto aggressive model..........................................................................................96
CHAPTER 5 DISCUSSION AND CONCLUSIONS.............................................................98
5.1 Summary.........................................................................................................................98
5.2 Theoretical implications.................................................................................................98
5.3 Practical implications.....................................................................................................99
5.4 Limitations of research...................................................................................................99
5.5 Reflections....................................................................................................................100
5.6 Conclusion....................................................................................................................101
REFERENCES.......................................................................................................................102

INDEX OF TABLES
Table 1 Currency prices of USD-HKD....................................................................................36
Table 2 Descriptive statistics of currency prices.....................................................................36
Table 3 Opening prices of USD and HKD...............................................................................54
Table 4 Descriptive statistics of opening prices of USD and HKD.........................................55
Table 5 Low prices...................................................................................................................64
Table 6 Descriptive statistics of low prices..............................................................................64
Table 7 % changes in prices....................................................................................................73
Table 8 Regression Statistics...................................................................................................74
Table 9 ANOVA........................................................................................................................74
Table 10 RESIDUAL OUTPUT...............................................................................................75
Table 11 PROBABILITY OUTPUT..........................................................................................76
Table 12 Residual Plot.............................................................................................................76
Table 13 Normal Probability plot............................................................................................77
Table 14 Spot Exchange rates..................................................................................................80
Table 15 Regression analysis...................................................................................................86
Table 16 Regression Statistics.................................................................................................86
Table 17 ANOVA......................................................................................................................86
Table 18 RESIDUAL OUTPUT...............................................................................................88
Table 19 PROBABILITY OUTPUT..........................................................................................90
Table 20 Residual Plot.............................................................................................................91
Table 21 Line Fit Plot.............................................................................................................92
Table 22 Normal Probability plot............................................................................................93
Table 23 Interest rates of USD and HKD................................................................................95
Table 24 SUMMARY OUTPUT...............................................................................................95
Table 25 ANOVA......................................................................................................................95
Table 26 Coefficient.................................................................................................................96
Table 27 RESIDUAL OUTPUT...............................................................................................97
Table 28 Residual Plot.............................................................................................................97
Table 29 Overnight swaps........................................................................................................97
Table 30 NDF 3 month swap rate............................................................................................98
Table 31 SUMMARY OUTPUT...............................................................................................98
Table 32 ANOVA......................................................................................................................98
Table 33 Coefficient.................................................................................................................98
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Table 34 RESIDUAL OUTPUT...............................................................................................98
CHAPTER 1 INTRODUCTION
Unique topic has selected for this research study that steals the attention of all the
technical or non-technical users. The users will get insights about market trends from this
study and to take enough benefit from this. Nowadays, the scope of the stock market and
forex trading has increased with time as everyone wants to earn higher profit by investing in
the forex market. The biggest reason behind the fewer investments in the forex trading is due
to lack of knowledge and awareness about this concept as no one knows about this concept in
detail due to which they can make investments decisions.
In increasing awareness among the people about this field, the researcher performs
this research study to explore the hidden or known aspects of the covered interest parity
conditions. The topic of this research is to determine the deviations from the covered interest
parity. The interest differentials between the swap rate and the interest rates analyses for this
research study. The majority of its audiences do not aware of this concept as by conducting
this research they will get to know about all the components of an investigation. Dependent
and independent variables developed for this study to generate the outcomes of a research
study.
This the study will target several components of research such as analysing the latest
interest rates, swap rates, closing values of the exchange rates and the currency values of two
of the countries. A researcher uses the cutting-edge data in this research which allows all the
investors to get updated with the latest results and this also help a user as a quick guide to
investing in the foreign market directly. It can say that this research study will act as an
instruction manual or a study guide that allow a newbie to enter into the international
financial market and money market and invests in a suitable asset that generates a higher
return. The risks will get decreases by a user by itself by taking help of investment analysis
tools such as VAR and regression analysis as discussed in this report.
The topic of this research study is the deviations from the covered interest parity in
the Hong-Kong denote that a researcher will identify the factors that are the cause roots of the
changes in the CIP. This study will reflect the theoretical and empirical investigations
conducted in this research analysis by deeply exploring all the facts relates to this study. This
study initially conducts the literature review which will describe the theoretical perspectives
of research. The abstract framework shows the relationships of a research variable such as
overnight swaps and the NDF swap rate identifies using Vector auto-regression model to
check the relationship among these two elements.
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A Motive of a researcher behind selecting this model is to know its further impact.
The researcher analyses to know its final impact on the main objective of the research. The
interest rate differentials and the spot exchange rates of USD and HKD identify by a
researcher using simple ordinary linear coefficients tests which is one of a kind of regression
analysis that uses residual plots and line fit plots for comparing the data. This tool will show
whether the data will fit in a straight line will get out of a mark.
The empirical investigation reveals the real efforts of a researcher in performing this
research study that says about the positive or increasing trend of the currency value of US and
Hong-Kong from one period to another due to the low inflation rate. Negative estimated
results about spot exchange rates and the currency prices of two of the countries that the
unfavourable outcome signifies no correlation between these two components. The negative
consequence is determine as these affect by the external environment all the factors such as
political, economic and cultural factors are which are primary suspects of triggering changes
in the covered interest parity. By linking the singular results of all the analysis performed by
a user in this study, the final result is a summation of all the examination that says that the
covered interest parity’s condition is not as good as the deteriorated position of CIP has
witnessed by all the users. The empirical investigation along with the theoretical study will
aid an individual in compiling its final report that the research objectives successfully tested
and the result is not in favour of the party as CIP is negative.
After the completion of this research, an individual got to learn several lessons of
keeping patience, working systematically by managing the time, using authentic and reliable
information from the credible sources. All these lessons learnt from this study will help a
person in performing systematic research in the future to get it complete before the stipulated
time of research.
This study will challenges the future research scholars in terms of knowledge and
quality of information mention in a research. A user will get to know about special features
of covered interest parity by reading this dissertation. They will get an experience while
performing this study as they get a clue to perform its own research in the future by taking
help or guide for their own research.
Considering the issue takes places in research, the entire study will get changes by making
modifications in the file by changing the timeline of this project, using different
methodologies of the research study. Un-available data and time- consuming research process
will results in an estimate of project failure as due to this the interest of a researcher gets
decreases.
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CHAPTER 2 LITERATURE REVIEW AND THEORY
2.1 Literature Review
2.1.1. Changes take places in the covered interest parity in Hong Kong
Glau, Grbac, Scherer & Zagst, 2016), has asserted that covered interest parity is a
term that denotes the actual meaning of this term that shows the interest rate differential
between two currencies. The study says that the interest differential of the two currencies in
the cash market should get equal the shortcomings lie in the forward and the spot exchange
rates (Wong, Leung & Ng, 2017). The covered interest parity is a close examination of the
interest differential of the two currencies dealing in the international market to know the
impact of the external market on its trading. Increasing or decreasing covered interest parity
will, in turn, shows its overall effect on the currency value of two of the countries.
According to the viewpoint of Avdjiev, Du, Koch & Shin, 2016), says that due to the
global financial crises immense reappraisal of the third party credit risks and the liquidity
risks in the international finance market has evident. This increasing risk will, in turn, change
the currency value of the country. The fluctuating position of the covered interest parity
amazes all the economists top think over on this matter again in estimating the reasons behind
this issue (Borio, McCauley McGuire & Sushko, 2016). The London interbank offered rate
also gets increases overnight whose purpose is not certain to the investment analysts due to
which the indexed swap rate has also increased. The sudden increase in the Libor and the
indexed swap rates is to be identifying throughout the research study.
The Motive of the researcher is to understand the cause behind that why covered
interest parity is no longer exists in the international finance market as what factors triggering
positive or negative changes in the growth of CIRP. From the perspective of the lender, the
counterparty risk is essential for borrowing which is not secured through collateral security as
a lender gets no return in exchange when giving loan to the borrower (Sushko, Borio,
McCauley & McGuire, 2017). On another hand, a lending party will enjoy interest or
something in return of the loan is given to a borrower by taking collateral security in
exchange for a credit. From the angle of swap indexed rate, the interest differential is identify
which signifies the difference between the forward and the spot interest rate. The interest
differential rate will act as a benchmark rate that will help spot rate and the forward rate too
show increasing performance (Du, Tepper & Verdelhan, 2018). The investments in the stock
market will get beneficiary advantages due to the growing performance of these two rates.
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Another theory says that the difference among the domestic and foreign currencies is the
interest differential rate.
As per the viewpoint of Osei-Kyei & Chan, (2017), a factor held responsible for
changing covered interest parity in Hong-Kong is due to the transactions costs of investment
in the international finance market. Due to the existence of transaction costs, the interest rates
and the exchange rates will get parallel to each other before investing in the market. It says
that when an individual capitalizes in the market, then the interest and the exchange rates gets
equal but when the same individuals borrow from another party in same market will consider
as a foreign currency exchange.
Cheng & Wu, (2017), says that another factor causing changes in the covered interest
parity of the given country are political risk as Hong-Kong contains two financial controls
such as of the current nation and the regulation of China. Two political rules and the
conventions applicable on this country which is not beneficial for the businesses and the
individuals trade in the international market. Fluctuations in the political rules and the
regulations of the nation will directly affect the covered interest parity. This will in, turn,
creates severe changes in the interest rate as due to turbulence in the political structure of the
nation. Due to the changes in the political conditions of the nations, an investors has to face
higher interest rate which will get stabilizes by interest rate parity as this will rectify the
situations of the external market (Baldwin, Brunsdon, Gaudoin & Hirsch, 2018).
From the viewpoint of Liao, (2016), that says that withholding tax is another point
that held responsible for deviations in the interest rate parity (Halaweh, 2018). While trading
in the international market, when a domestic user pay to the foreign party then the taxes
withhold to that payment has to deposit to the government before clearing the payment made
to the other party. Poor condition of the covered interest parity of the Hong-Kong is due to
the changing taxation policies of the nation as the value of tax withhold on the payment to the
foreign party was higher than the actual payment (Kerr, 2018). This leads to the problems
which, in turn, decreases the forward and the spot rate who direct impact show on the overall
performance of the interest rate parity. Due to this situation, the value of Hong-Kong dollar
weakens as compared to other currencies in the international market (Whicher, Philbin &
Aronson, 2018). It is essential to closely observe the taxation rates and the overall structure to
safeguard the position of IRP (Interest rate parity of the nation (Zhao, Valdes-Vasquez,
Simmons & Parrish, 2018, January).
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Nishimura & Ozaki, (2017), says that liquidity preference is another issues identifies
by a researcher when detailed analysis conducted to analyse the position of the covered
interest party of the nation (van Veen, 2018). It is essential to now all the factors which is
affecting the currency value of Hong-Kong to eliminate the effect of all the factors which is
creating issues for the nation. After knowing its effect, actions will take by the government to
resolve all the issues. The liquidity of assets is to be identifying before investing in the
international market as this costs will also directly affects the interest rate parity (Levenko,
Oja & Staehr, 2019). Higher the costs involved in the converting the investments assets into
cash will increases the costs burden on an entity. The increasing liquidity costs will increases
the liquidity of an investment before its maturity which is not appropriate for investors.
2.1.2 Factors that causes differences between swap rate and interest rate in Hong
Kong
Hui, Lo & Fung, (2017), has asserted that latest research conducted to identify the
determinants held responsible for driving the Hong- Kong dollar interest rate swap spreads
are Liquidity and credit. From the perspective of the international market that considers swap
spread as an alternative way for banking liquidity (Bekaert & Mehl, 2019). Before
performing detailed analysis about these two factors that causes differences in the interest
rate and swap rate in the nation, it is essential to clarify this concept to aware its audiences
about its actual meaning and its significance.
Swap shows the trading relationship between two parties involved in exchanging cash
flows in the future period that utilizes swap interest rates (Benos, Payne & Vasios, 2018).
Commonly, fixed for floating method of swap interest rate uses by the parties to the
agreement where one party receives the variable interest rate payments and other party will
pay the fixed rate that is swap rate. The Hong-Kong dollar interest rate swap is very high as
compared to other countries in the counter market due to the favourable economic and
monetary conditions of this nation (Xia, You, Jiang & Guo, 2018).
International finance market releases two interpretations theories regarding swap
interest rates that firstly this is consider as an “ effective proxy for banking and liquidity” and
secondly, this is consider as a “ proxy for AA credit” (Fratzscher, Duca & Straub, 2016). This
theory determines two factors that cause differences between the interest rates and swap rates
in the nation. This research paper will analyses the major effect of one of a factor for the
differences caused in the swap spread.
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In the second half of 2007, increase in the Hong- Kong dollar swap spreads has
witnessed which further collide with the occurrence of sub-prime crises in the United States.
This crisis has affected the value of swap spreads of the nation and also affects the famous
financial institutions of the United States (Kwan, Wong & Hui, 2015). Two of the reasons
come in a bigger picture stating the effect of this rises on the interest rates swap of Hong
Kong due to credit concern and the liquidity concern (Gonenc & Ursu, 2018). This
preliminary investigations about two of the factors identifies with the help of Vector-Error
correction model. This model helps in analysing the time series of this crisis to track the
effect of this crisis on the performance of Hong- Kong dollar and the swap spreads (Vokić,
Klindžić & Hernaus, 2018).
In continuation to this, the time series of swap spreads and Hong- Kong Interbank
offered rate and the credit spreads are also analyses to identify the main reason behind the
fluctuating trends (Li, Shi, Allan & Evans, 2019). After the end of this model’s analysis
(Giglio, 2016). The major effect for the deviations of swap spread is due to the increasing
liquidity risks that induces the interest rates. In the swap spreads, interest rate is variable in
nature and swap is fixed in nature which remains the same throughout the changes in the
market. Higher the changes in the market, higher will be the interest rates (González,
Oosterlynck, Ribera-Fumaz & Rossi, 2018).
After identifying the liquidity risks triggering changes in the swap spreads, the next
factor is identified by applying by convenience yield model. This model shows that another
factor causing higher changes in the swap spreads is credit risks (John, S., Oosterlynck,
Ribera-Fumaz & Rossi, 2019). This model tracks the increasing trends of the swap interest
rates which are due to credit spreads of non-government bonds of the nation (Badaoui,
Cathcart & El-Jahel, 2016). This credit spreads shows the difference between the returns
generated over the period from the exchange fund of Hong- Kong. The Credit value of nom-
government fund bonds is tracked by using index values of HSB weighted return scales
(Höllerer, Jancsary & Grafström, 2018). The values determined by using this scale. Inclining
or declining trend of this weighted scale will in return shows the impact of credit risks for
swap spreads. By measuring the trends of this scale, the government will eliminate the credit
risks affecting the performance of swap spreads. The interest rate swap spreads shows the
strength of an investor while trading in the external market.
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The time series of the swap spreads is tested by using the break point tests by
considering two of the determinants such as liquidity and the credit risks affecting the swap
spreads. Structural changes has observes by an investors in analysing the overall performance
of the interest rates and the swap rates (Bai & Wu, 2016). The three refinements introduces
by the Hong- Kong government in decreasing pressures of the external market in stabilizing
the deviations of the swap rates and the interest rates. Three refinements are linked exchange
rate system, emergence of US-subprime crisis and Injection of cross bank liquidity
considering as the triggering factors for the changes in the swap spreads of the country. All
the monetary and the nom-monetary factors are also taken into account in analysing the entire
performance of the interest swap spreads (Cayon, Thorp & Wu, 2018).
2.1.3 To tests the validity of the covered interest parity in Hong-Kong
Ito, (2018), has asserted that it is essential to tests the validity and the authenticity of the
covered interest parity to make sure that all the information about the forward and the spot
rates of the cross countries (Bruno, Kim & Shin, 2018). By testing the validity of this model a
researcher will uses an appropriate way to estimate the authenticity of the model and the
information use in building the same (Schmidt, Caccavaio, Carpinelli & Marinelli, 2018).
The economic status of two of the trading entries can be analysed by identifying the valid
data about the covered interest parity. In this phase, rank approach is used by an evaluator in
testing the covered interest parity of the cross currencies by analysing the currencies of Hong-
Kong and the US dollar (Lane & Milesi-Ferretti, 2018). As the covered interest parity depicts
the relationship between the two country’s interest rates in a trading market along with its
own forward and the spot exchange rates when they trade with each other (Cifarelli &
Paladino, 2018). These two rates are important to trade in the international finance market
which decides the destiny of an investor to generate higher returns in the future competitive
market. By keeping track on these two rates, an investor’s will able to decrease its trade
obligations and transform them into its strengths.
(1+Rdk)= Fk/S (1+Rfk)
The above mention formula is a criterion of this approach to tests the efficiency and
effectiveness of the covered interest parity by analysing its components such as exchange
rates and the spot rates (Suh, 2018). These spot, forward and the interest rates will differ from
period to period depends on the circumstances.
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Rdk denotes the nominal interest rate of a local or domestic country at the time of the
maturity. A maturity period of an investment means the completion of the time period for
which an investment holds in the money market (Christensen & Krogstrup, 2018). On
another hand, Rfk signifies the nominal interest rate of the foreign country at the maturity date
(Cheung, Hui & Tsang, 2018). Fk shows nominal forward rate and S denotes the spot
exchange rates of an investments. It can says that forward and spot rates describes the identity
of an investment as by using these rates the nature of the interest rate is determined to know
whether an investment will succeed or will get fail at the time of a maturity date (Shi & Wu,
2018).
In the international finance market, there are a lot of opportunities as several entities
are trading in this field as everyone wants to earn higher profit which, in turn increases the
level of market risk along with the increasing competition level of an international market
(Berg & Mark, 2018). Covered interest parity will act as a benchmark that inspires all the
traders in the money market to beat the increasing market risks and earn its desired profit in a
stipulated time period (Avdjiev, Bruno, Koch & Shin, 2019). This benchmark will help a
trader to earn riskless profit by eliminating all the risks and the issues take places in the
external environment (Kennedy-Hendricks and et al., 2018).
B= Fk/S (1+Rfk)-(1+Rdk)
B denotes the cross currency basis which is the main thing that is evaluates by a
researcher in testing the validity of the covered interest parity of two of the countries trades in
the money market to get the enough returns at the maturity date (Bernstein, Hughson &
Weidenmier, 2019). Using this criterion, the deviations incurred in the interest parity can be
tracked as in the actual money market, the fluctuations on the interest parity conditions are
observed from zero to another level in order to determine the element held responsible for
this fluctuations or deviations (Pumir, Jelassi & Boumal, 2018). Increasing or decreasing
value of the transactions costs involved in an investment agreement held responsible for a
minute change take place in the covered interest parity. Increasing costs of the transactions of
an investment will direly affects the value of the host country that holds investments in the
international market (Biswas, Kumar & Prakash, 2019).
With the emergence of covered interest parity’s concept through various empirical
studies conducted on this field are underestimated by some of the economists and the
financial experts that consider this topic as vague (Warburton, 2018). But due to the
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international financial crisis, the image of covered interest parity gets cleared in the eyes of
economists and the financial professionals. As they witness increasing deviations in the CIP
in the international market due to the direct effect of this event. Several real examples take
places in the market is enough to prove this statement that the scope of CIRP has increases
due to the global financial crisis in the money market (Cayon, Thorp & Wu, 2018). Though,
event affects several entities and traders by spoiling the returns of the investments holds by
an investor. Failure of Libor based CIP has witness after the year 2007 in relation to the G 10
currencies for both short run and the long run. Due to the event incurred in the year 2007,
where the value of US dollar shows negative value which shows the fluctuations of the
Covered interest parity in the currency market. Violations in the CIP is not due to global
financial crisis as this has changes visible in the performance of CIPT even before than this
event (Iida, Kimura & Sudo, 2018). This shows that the covered interest parity gets affected
with the external as well as internal environment which is responsible for the deviations
taking place in the CIP. Turbulences in the international finance market are another reason
for shifting the movement of the Interest parity conditions in moving from left to right.
Other factors held responsible for the fluctuations of the covered interest parity
conditions to hold an investment in the international market that banking regulations also
affect CIP. Forward rate and spot rate’s interest rates will get differ from on period to another
due to banking rules and the regulations as every banks work according to the order of the
Apex bank that is reserve bank (Morse, 2019). Due to tough banking conditions where a bank
struggling to meet its capital and liquidity requirements due to which the trade will get risk
free but at the same time, the condition of CIP gets deteriorated. This severe condition of the
CIP gets affected as interest parity will fail to hold its position in the external market due to
uncomfortable situations faces by an entity in the international money market (Wang and et
al., 2018). The analysis also proves that the excessive fluctuations or changes in the CIRP
incurred due to the increasing transactions costs and higher operational risks. In the presence
of these two risks such as increasing costs and the operational and the financial risks affects
the position of CIRP and all the investments associates with it gets affected.
2.1.4 Impact of foreign exchange liquidity conditions of a bank on Covered interest
parity
As per the view of Hassan & Mano, (2018), that the concept of covered interest parity
shows the holding of interest paid by an investor on two assets of a similar category that of
different currency’s type gets equalize with the foreign exchange rate (Gallien, Kassibrakis,
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