Covered interest parity: A stochastic volatility approach to estimate the neutral band

The neutral band is the interval where deviations from Covered Interest Parity (CIP) are not considered meaningful arbitrage opportunities. The band is determined by transaction costs and risk associated to arbitrage. Seemingly large deviations from CIP in the foreign exchange markets for the US Dollar crosses with Sterling, Euro and Mexican Peso have been the norm since the Global Financial Crisis. The topic has attracted a lot of attention in the literature. There are no estimates of the neutral band to assess whether deviations from CIP reflect actual arbitrage opportunities, however. This paper proposes an estimate of the neutral band based on the one-step-ahead density forecast obtained from a stochastic volatility model. Comparison across models is made using the log-score statistic and the probability integral transformation. The stochastic volatility models have the best fit and forecasting performance, hence superior neutral band estimates.