Interest Arbitrage and Interest Rates in Korea

The Bank of Korea has raised its policy rate by 1.75 %p since mid-2005 but yields on 3-year government bonds increased by just 1%p for the same period. Some argue that interest arbitrage, which happened when the covered interest rate parity condition was broken in 2006 and 2007, increased the demand for Korean bonds and, as a result, decreased interest rates. We set up a small open DSGE model and estimate it using Bayesian methods to see whether the argument is right. The estimation results show that a decrease in the risk premium in the foreign exchange market, which is a necessary condition for interest arbitrage, is significantly associated with a fall in interest rates. In addition, the link between the foreign exchange market and the domestic bond market has been more strengthened since the Asian currency crisis.