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Uncovered interest rate parity: A gravity-panel approach.

ABSTRACT: This paper investigates the validity of uncovered interest rate parity (UIRP) which establishes a proportional relationship between interest rate and expected nominal exchange rate differentials. This paper takes a different perspective by using a gravity panel as the methodological approach and modeling the interest rate differential as a function of the expected nominal exchange rate change. Thus, we use all possible nominal exchange rates in our sample to study the validity of the UIRP. We provide evidence in favor of UIRP which holds for a sample of high-income economies; however, this hypothesis is rejected for medium-income countries.

SUBMITTER: Orellana V

PROVIDER: S-EPMC8593457 | biostudies-literature | 2021 Nov

REPOSITORIES: biostudies-literature

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Uncovered interest rate parity: A gravity-panel approach.

Orellana Vanessa V Pino Gabriel G

Heliyon 20211110 11

This paper investigates the validity of uncovered interest rate parity (UIRP) which establishes a proportional relationship between interest rate and expected nominal exchange rate differentials. This paper takes a different perspective by using a gravity panel as the methodological approach and modeling the interest rate differential as a function of the expected nominal exchange rate change. Thus, we use all possible nominal exchange rates in our sample to study the validity of the UIRP. We pr ...[more]

PMID: 34816042

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Project description:Credit value adjustment (CVA) is an adjustment to an existing trading price based on the counterparty-risk premium. Currently, CVA is computed with an implicit assumption that the replacement contract is default-free after the original counterparty defaults, with the assumption that those trades will not re-assigned. In the actual counterparty default settlement, it is the norm that trades will be re-assigned, especially on the buy side. Since the counterparty of the replacement contract could also default within the lifetime of an existing contract, ignoring the possibility of counterparty defaults of replacement contracts will either under or over estimate the cost of the risk. An important practical question is, therefore, how to estimate under/over pricing of CVA under current practice. In this paper, we considered the pricing of credit contingent interest rate swap (CCIRS) or credit contingent default swap (CCDS), which is considered the CVA hedge for interest rate swaps (IRS). We derived partial differential Eqs. (PDEs) satisfied by the approximated CVA with the assumption that the replacement contracts do not default. For comparison purposes, we also derived the PDEs for the cost of CVA by relaxing the assumption of default-free replacement contracts with a finite number of counterparty defaults. It shows that the no-default and two default cases can be derived within the same analytical solution framework, similar to the Funding Valuation Adjustment (FVA) problem where continuous funding is a reasonable assumption. The finite number of default case is non-trivial. The PDE for the two default case is derived in this paper. We calibrate our model based on market data and carry out extensive computations for the purpose of comparing these three CVAs. Our basic finding is that the values of the two CVAs are close for top rated counterparties. On the other hand, for counterparties with lower credit ratings, the difference among the two CVAs can be significant.

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Uncovered interest rate parity: A gravity-panel approach.

Publications

Uncovered interest rate parity: A gravity-panel approach.

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