FOREIGN CURRENCY SPECULATION An interest parity approach to investigate the opportunities for making speculative profits in the foreign exchange market

Abstract

The foreign exchange market is a very large and liquid market all over the world. Daily trades in foreign exchange amount to enormous sums that are larger than the annual GDP of several countries. The question remains of whether a market of this size and trading volume is efficient. According to the theory of interest parity, it should not be possible to achieve speculative profits by engaging in carrying trades between different currencies since returns on deposits should be equal in all currencies. However, there are deviations from interest parity since the theory does not always hold. This creates opportunities for making speculative profits. This thesis tests whether it is possible to make speculative profits in the foreign exchange market through so called carrying trades. We test to what extent interest parity holds between several currencies with large interest differentials over different maturities. The conclusion is that interest parity does not hold well for several currency combinations. Specific patterns were found for certain currencies. The Japanese yen, which is a low interest rate currency, does not appreciate as much as indicated by the interest differential relative to all currencies tested. The Indonesian rupiah, which is a high interest rate currency, does not depreciate by as much as it should relative to most of the currencies tested.