Why exchange rate pass-through matters in forward exchange markets

• Published in: Economic modelling 2022-05, Vol.110, p.105795, Article 105795
• Main Authors: Choi, Yoonho, Choi, E. Kwan
• Format: Article
• Language: English
• Subjects: Covered interest rate parity; Exchange rate pass-through; Utility-equalizing forward rate
• ISSN: 0264-9993; 1873-6122
• DOI: 10.1016/j.econmod.2022.105795

Persistent deviations from a covered interest rate parity (CIRP) have been observed between the United States (US) and the United Kingdom (UK) from January 2002 to August 2020. This study argues that the CIRP does not hold because even if income from domestic and foreign investments is equalized, foreign investment's utility could be higher than that of domestic investment depending on the exchange rate pass-through (ERPT) into import price. Theoretically, the deviations of observed forward exchange rates from CIRP conditions are attributed to changes in importable goods prices and ERPT. A change in net capital flow affects import price volatilities and deviations from the CIRP. Therefore, the forward exchange rate depends not only on the interest rate differential between countries but also on ERPT into the import price. Using a logarithmic utility function, this study derives a utility-equalizing forward rate (UEFR). An increase in net capital outflow and the ERPT into the import price reduces the UEFR. Our empirical evidence shows that from December 2011 to June 2020, the UEFR estimates trace the actual US−UK forward exchange rates better than CIRP. •CIRP is a special case of UEFR when ERPT into the import price is zero.•Capital outflow increases an investor's utility despite income preservation at CIRP.•An increase in ERPT into the import price raises the deviation from CIRP.•UEFR estimates are better than CIRP estimates of the US–UK forward exchange rates.