Covered interest parity: A forecasting approach to estimate the neutral band

This paper introduces a new approach to estimate the neutral band, where deviations from covered interest parity (CIP) are not considered profitable arbitrage opportunities. The approach fills a gap in the literature on international finance and is theoretically grounded. Using daily Pound Sterling-US Dollar data from 2000 to 2021, I illustrate that estimates based on the forecast distribution of CIP deviations with a time-varying variance component are superior to the mean-based estimates currently available. The results reveal that the estimated neutral band adapts to market dynamics, widening from 3 to 191 basis points as financial stress and volatility increase. The forecasting approach is further validated on G10 and emerging market currency pairs. Market participants can use these findings to set minimum profit targets in CIP trading, while policymakers can assess the liquidity of the foreign exchange market more effectively. • I propose a new approach to obtain the neutral band about CIP deviations. • The approach uses forecasts on CIP deviations with time-varying variance. • The proposed neutral band widens with stress in markets. • The approach is validated on G10 and emerging market currency pairs. • The GBP-USD band widens from 3 to 191 basis points with financial stress.