What is the empirical evidence on how well covered interest parity actually held for major currencies during 1990-2012? What effect did the global financial and economic crisis have? What effect did the euro crisis have?

What will be an ideal response?

POSSIBLE RESPONSE: The empirical evidence shows that the covered interest-rate parity generally held closely for the major currencies up to 2007. However, covered interest parity relationships that hold well during normal times can break down during times of crisis such as the global financial and economic crisis that began in 2007 and worsened in 2008. After some large fluctuations, the differentials became smaller and less variable by early 2009. Still, covered interest differentials remained larger than they had been before August 2007.

During 2010 and the first half of 2011, the euro crisis was initially focused on Greece, Ireland, and Portugal. There was no additional effect on deviations from covered interest parity. In mid-2011 new concerns arose that Spain and Italy, much larger countries, could require large bailout assistance; that Greece might be forced somehow to exit the euro area; and that the monetary union itself could enter a period of turmoil and possible collapse. With new concerns about bank obligations in euros, the deviations from covered interest parity for the euro relative to the dollar widened to about 1.5 percentage points in late 2011. However, the same deviations for the pound relative to the dollar were not observed. As the euro crisis abated, and as the financial system moved further away from the global financial crisis, the differentials became smaller. 

During these crises, the large deviations from covered interest parity can be attributed to a failure on banks' part to exploit the covered interest differentials that existed. While forward cover eliminates exchange-rate risk, it does not remove the risks of relying on the other parties to the arbitrage transactions to fulfill their sides of the contracts, both the future delivery of currency to settle forward foreign exchange contracts and the future repayment of loans. In normal times, the risk of dealing with other large banks is considered minimal. But during the global crisis, perceptions of such counterparty risks rose to high levels, based on the chance that other banks had large, unrevealed losses that could bring them down. Similar concerns arose during the euro crisis, though to a lesser extent and focused on the euro. Without a highly elastic supply of funds willing to undertake covered interest arbitrage, covered interest differentials can widen.