Interest Arbitrage between Canada and the United States: A New Perspective

Abstract

This study uses cross-spectral analysis to examine the relation between forward premiums and interest rate differentials for Canada and the United States. The observations are weekly and cover the period 1959 to 1975. The results suggest that interest rates are endogenous and that the elasticity of supply for arbitrage funds increases from zero in the short run to infinite in the long run. Arbitrage et diferentiels de taux d'interet entre le Canada et les Etats-Unis: une perspective nouvelle. Cette etude utilise les methodes d'analyse spectrale croisee pour examiner la relation entre le differentiel Canada/Etats-Unis dans les taux d'interet et le differentiel dans le taux de change entre le marche ferme et le marche a terme. L'auteur utilise les donnees hebdomadaires pour la periode 1959-75. L'analyse suggere que les taux d'interet sont des variables endogenes et que l'elasticite de l'offre de fonds pour fins d'arbitrage passe de zero dans le court terme a l'infini dans le long terme. All studies of covered interest rate arbitrage between Canada and the United States treat the interest rate differential as an exogenous variable.' Moreover, excepting Stein (1965), the studies are based on a comparative static model which excludes the possibility that elasticity of supply for arbitrage funds increases with the length of the run.2 The results of such research are interpreted as evidence that 'the' elasticity of supply for arbitrage funds is less than infinite because arbitragers require a risk or liquidity premium. This study takes a new look at arbitrage between Canada and the United I thank Edward Tower, Charles Freedman, and the anonymous referees for their helpful comments. 1 See e.g. Grubel (1966), Kesselman (1971), Stein (1965), and Stoll (1968). Several other studies have used either net covered yields or forward premiums and interest rate differentials as explanatory variables for short-term capital flows between Canada and the United States. For a review of the literature on short-term capital flows see Hodjera (1973). 2 At least three unpublished studies permit supply elasticity to increase with length of the run: Pippenger (1972, 1977) and Pedersson and Tower (1976). Pedersson and Tower, however, treat the interest rate differential as an exogenous variable. Canadian Journal of Economics/Revue canadienne d'Economique, XI, no. 2 May/mai 1978. Printed in Canada/Imprim6 au Canada. 0008-4085/78/0000-0183 $01.50/?1978 Canadian Economics Association This content downloaded from 207.46.13.64 on Sat, 03 Sep 2016 04:42:49 UTC All use subject to http://about.jstor.org/terms 184 / John Pippenger States. In the model developed here, forward premiums and interest rate differentials are treated as endogenous variables, and supply elasticity for arbitrage funds can increase with the length of the run. In addition, the study uses cross-spectral rather than regression analysis to examine weekly forward premiums and interest rate differentials between the two countries from 1959 through 1975. The major conclusions are, first, that interest rate differentials are endogenous and the elasticity of supply for arbitrage funds increases from almost zero in the short run to effectively infinite in the long run, and, second, since the mid-1960s, estimates using treasury bill differentials have not conformed to the general pattern.