Deviations from covered interest parity: the role played by fundamentals, financial and political turmoils and market frictions

Abstract

Recent works for mature markets on covered interest parity suggest that deviations are mean reverting but persistent particularly after 2008 crisis (Du et al., 2018). Our study aims to contribute to the literature by modelling the deviations from covered interest rate parity (CIP) of an important emerging market economy. We focus on Brazilian data given the importance of its derivative market. One of strengths of our study is the use of an agnostic approach based on automatic model selection technique robust to structural change, the Autometrics algorithm (Hendry and Doornik, 2014), to unveil possible determinants of CIP deviations from a wide information data set. We show that CIP deviations are highly sensitive to changes in Federal government total debt, level of reserves, in ation and degree of trade openness. We also document the existence of instabilities in the model due to nancial and political turmoils. These conclusions come up from the intercept correction performed by the algorithm and can be seen as byproduct of our method- ology. Finally, we collect evidence that, even after corrected for fundamentals and instability points, CIP deviations still have persistence, suggesting that market frictions play an important role in the dynamics of CIP deviations.