Abstract
The Interest Parity Theory states that in an efficient market, any interest differential between local and foreign sources of finance will be offset by the forward premium/discount. Therefore, opportunities to engage in profitable Covered Interest Arbitrage transactions will be eliminated quickly. The fall in the Rand/Dollar exchange rate resulted in many South African companies reporting substantial foreign exchange losses on offshore loans. Companies were attracted to foreign sources of finance because of lower foreign interest rates. The authors conclude, on the basis of empirical tests, that the forward Rand/Dollar exchange rate followed its interest parity value very closely over the period August 1983 - August 1985. Opportunities to engage in risk-free arbitrage activities were offset by related transaction costs. The South African foreign exchange market is efficient to the extent that risk-free profit opportunities did not exist for the period under review and therefore there was no benefit, after adjusting for risk, for South African management to borrow from offshore sources of finance.
Highlights
In this paper the efficiency of the South African foreign exchange market is tested regarding quick elimination of risk-free profit opportunities
This paper focuses attention upon situations where the forward dollar premium deviates from its interest parity value
Apparent risk-free arbitrage profit opportunities did exist over the period August 1983 - August 1985 but these were offset by related transaction costs
Summary
In this paper the efficiency of the South African foreign exchange market is tested regarding quick elimination of risk-free profit opportunities. Interest parity deviations will not imply that the foreign exchange market is inefficient if apparent covered interest arbitrage profit opportunities are not sufficient to offset related transaction costs. The only countries studied are South Africa and the U.S.A. The authors found that deviations from interest parity did occur during the period August 1983 - August 1985, but these apparent risk-free arbitrage profit opportunities were not sufficient to offset relevant transaction costs. The hypothesis that the South African foreign exchange market has met a basic requirement for market efficiency, that is, risk-free profit opportunities should be quickly eliminated, cannot be rejected as a result of this study
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