Testing the Effectiveness of Arbitrage and Speculation under Flexible Exchange Rates

This paper presents some empirical evidence on the traditional covered interest parity theory and the modem theory of forward exchange under the current system of floating exchange rates. It is argued that reintegration analysis is more appropriate for testing these theories and that it is erroneous to test the restrictions implied by these theories on the basis of the conventional standard errors and t statistics. One specification of the former and two specifications of the latter are estimated using an expectations formation mechanism that is a special case of rational expectations. The results favour the traditional covered interest parity theory, giving almost all the weight to arbitrage and almost nothing to speculation in the determination of the forward exchange rate. These results are consistent with the proposition that financial deregulation, abolition of capital controls and the integration of financial markets have created an ideal environment for the operation of covered interest parity.