Interest rate dynamics and speculative trading in a fixed exchange rate system

Recent evidence provided by Diebold, Gardeazabal, and Yilmaz (1994) for the post-1973 floating rate period points toward the predictive superiority of a martingale representation of exchange rate evolution over that of an error correction model that assumes rates are cointegrated. This is an appealing result from the perspective of efficient assimilation of randomly arriving information. As a direct extension of informational efficiency in a fixed exchange rate regime, I show that information is processed and assimilated through the medium of interest rates. Specifically, I demonstrate that interest rates cannot be represented as a cointegrated system, even when the central bank is willing to establish its determination and resolve to maintain the fixed rate rule over a sustained and prolonged period of time. Evidence provided in this paper is for the interest rate behavior of the Saudi Arabian Riyal with respect to the eurodollar interest rate, the interest rate on the intervention currency.