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Choosing Interest Rates for Covered Interest Parity Tests

Article Quant Q&A · Author: brett
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Summary

The document asks which interest rates are appropriate for empirical covered interest parity testing between Canada and the United States across several forward maturities. It raises a practical concern with Treasury bill rates: their lending yield may not represent the rate at which a market participant can borrow. The questioner uses US and Canadian LIBOR, while noting that Canadian LIBOR had been discontinued, and asks whether that proxy remains adequate.

The replies describe common alternatives rather than prescribe one universal rate. They mention Treasury bill or short-term bank deposit rates, prefer overnight indexed swap rates for recent periods, and suggest LIBOR when OIS data are unavailable, with central bank target rates as a further fallback. The discussion is brief and offers no empirical comparison of these choices or detailed guidance on matching instruments, maturities, credit risk, or data availability. Rate selection should therefore reflect the period and market being tested, and the resulting measure may depend on the chosen proxy.

Key ideas

  • Covered interest parity tests require interest rate inputs matched to the relevant currencies and forward maturities.
  • Treasury bill yields are one possible input, though the question raises whether lending rates represent borrowing costs.
  • Short-term bank deposit rates are another rate proxy mentioned in the discussion.
  • The replies suggest OIS rates for recent periods, LIBOR where OIS data are unavailable, and central bank target rates as a fallback.
  • The discussion does not compare these proxies empirically or establish a single best choice.

Tags

ForexFixed incomeArbitrageStatistics
Full text
# What interest rate should I use for testing the covered interest parity?


# What interest rate should I use for testing the covered interest parity?












I am doing an empirical test of the CIP from the recent financial crisis between Canada and the United States. I am using 1,2,3,6,12 month forwards (monthly data). What interest rates should I use? I don't think T-bills are suitable because you can lend at that rate, but not borrow. Currently I am using LIBOR rates for the US and Canada (even though the Canadian LIBOR was discontinued in 2013 I think it is sufficient). Any feedback would be appreciated.

Thank you.

## Answer by Alex C (score 1)

https://quant.stackexchange.com/a/18357

I believe in the literature they use either the T-bill rate or short term bank deposit rate.

## Answer by Helin (score 1)

https://quant.stackexchange.com/a/18363

My personal preference is to use OIS rate for recent years, and LIBOR when OIS isn't available. If neither is available, CB target rate can also be used.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.