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Covered interest parity: a forecasting approach to estimate the neutral band
The neutral band is the interval where deviations from covered interest parity (CIP) are not considered profitable arbitrage opportunities. After the great financial crisis, deviations from CIP are no longer short-lived, exposing some limitations of the previous approaches to estimate the neutral band. In this paper, I argue that the one-step-ahead forecast distribution of deviations from CIP, with a time-varying variance component, provides an intuitive estimate of the neutral band. I use data for the Pound Sterling-US Dollar cross from 2000 to 2021, and find that a stochastic volatility model outperforms several alternative models in terms of fit and forecasting capability. The model estimates neutral band that are intuitive and consistent with market dynamics, widening during financial stress periods and consistent with no arbitrage. The results are maintained when I use data from the Mexican Peso-US Dollar cross.
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