Covered interest parity and arbitrage paradox in emerging markets: Evidence from the Korean market

• We develop a modified covered interest parity condition to test market efficiency for emerging forward exchange markets.
• In addition, we apply the notion of ‘arbitrage paradox’ to examine the persistence of arbitrage opportunities.
• We apply this methodology to the Korean forward exchange market.
• Empirical results for the Korean market can be useful for analyzing other emerging markets.

While emerging forward exchange markets (EMs) have been rapidly developed, market efficiency has rarely been examined for EMs. To properly test the market efficiency for EMs, we set up a simple model to account for EM-specific realistic features. Based on the new model, we develop a modified covered interest parity (CIP) condition, which features multiple neutral bands associated with both transaction costs and differential borrowing costs. In addition, we apply the notion of ‘arbitrage paradox’ to test market efficiency. In particular, we focus not only on the violation event of the (modified) CIP condition but also on the persistence of arbitrage opportunities. We then apply this methodology to the Korean forward exchange market and provide empirical results for the Korean market, which can also be useful for analyzing other EMs.