Interest and price parity and foreign-exchange market-efficiency - the Irish experience in the European monetary-system

Abstract

Purchasing power parity, interest rate parity and the question of whether the forward exchange rate is an unbiased predictor of the future spot exchange rate are all important relationships underlying exchange rate theory. The objective of this paper is to empirically evaluate the usefulness of these relationships in forecasting Ireland's sterling exchange rate and in doing so, to discuss certain issues relating to the EMS entry decision. The results suggest a breakdown of the long standing price and interest parity relationship between Ireland and the UK following EMS entry. The results also indicate that Ireland's sterling spot market does follow a random walk process and that the three month forward exchange rate is an unbiased predictor of the future spot exchange rate. A risk premium was also found to be important in forward contracts.