Real interest rate parity in practice: Evidence from Asia‐pacific economies

Abstract

AbstractThis research investigates the relationship between real interest rate parity and the interest parity puzzle across several economies in the Asia‐Pacific region. Unlike previous studies, we establish a comprehensive theoretical framework for parity and utilize macroeconomic and financial market data from 15 economies in the region to examine it. Our findings indicate that most countries exhibit mild deviations from parity, with real interest rate differentials strongly correlated with changes in the real exchange rate and interest‐exchange rate interaction terms, particularly in middle‐income economies. While interest parity puzzle is also observed in high‐income economies, it is less prevalent in most middle‐income economies. Our analysis reveals that income levels are key drivers of deviations from parity in this model, with interaction terms also playing a crucial role in most cases. The implication here is that for carry trades, investors place significant importance on risk factors, especially in economies with relatively low risk. This insight helps to clarify a puzzle in this area. Therefore, it is imperative that investors should take into account the impact of interest‐exchange rate interaction terms when making carry trade decisions. Lastly, we underscore the significance of ex ante price forecast approaches in achieving parity.