Exchange Rates and Long‐Term Bonds*

There is tentative evidence to suggest that the well‐documented empirical failure of uncovered interest parity (UIP) is confined to short‐term interest rates. However, tests of UIP for long‐term bonds are thwarted by various data problems. These data problems can be avoided by focusing on short investments in long‐term bonds. This paper concerns the relationship between changes in the US dollar–Deutsche Mark exchange rate and returns to short investments in US and German long‐term government bonds. The hypothesis that expected returns to investments in bonds denominated in the two currencies are equal is not rejected, and the estimated slope coefficients are positive. For corresponding short‐term interest rates, the typical finding of negative and large Fama coefficients is confirmed. We conclude that it is the maturity of the asset, rather than the investment horizon, that matters for the results.     

Uncovered Interest Parity: Cross‐Sectional Evidence

Uncovered interest parity (UIP) is estimated for short‐term horizons from one month to 12 months using a large number of cross‐sectional bilateral exchange rates. In contrast to conventional time‐series UIP, cross‐sectional UIP is examined with a single‐equation estimation and panel regression model estimation. The exchange rates analyzed here include a broad spectrum of countries: developed, developing, low‐inflation, and high‐inflation countries. Based on the empirical evidence, there does not appear to be a well‐publicized UIP puzzle for cross‐sectional UIP, and the slope estimates remain largely between zero and one throughout the sample periods, with a few exceptions. Evidence of UIP is more clear for low inflation countries than for high inflation countries. As interest rate maturity becomes longer from one month to 12 months, the UIP relationship becomes weaker.     

The existence of uncovered interest parity in the CIS countries

This paper examines uncovered interest parity (UIP) for six countries of the Commonwealth of Independent States (CIS) – Armenia, Azerbaijan, Georgia, Kazakhstan, Kyrgyzstan and Moldova – using quarterly data on spot exchange and three-month Treasury bill interest rates over the period 1995:01–2010:02. Three model specifications are used: the conventional ‘approximate’ interest differential model specified in first differences of exchange rates and the two unconventional ‘precise’ models specified in levels of exchange rates. Results obtained from the former model are consistent with UIP, since the coefficient on the interest differential is positive in all cases. These results imply that the CIS currencies offering a significant interest differential tend, on average, to depreciate over the sample period as UIP predicts. Results from the latter two models are strongly supportive of UIP in the long run in all cases, except for Armenia when a restricted specification is used, and Armenia, Moldova and Georgia when an unrestricted specification is used. Yet the deviations from UIP that are allowed in the short run may lead to the profitability of carry trade in the CIS currencies offering the significant interest differentials. The results confirm that carry trade is highly lucrative in all the CIS currencies, and outperforms the U.S. stock market.     

Testing uncovered interest rate parity using LIBOR

We test uncovered interest rate parity (UIP) using London InterBank Offered Rate (LIBOR) interest rates for a wide range of maturities. In contrast to other markets, LIBOR markets have minimal frictions. Whereas most previous studies reject UIP, we find that UIP holds for several short-term LIBOR maturities using block bootstrap panel unit root tests suggested by Palm et al. (2011) and cointegration techniques by Westerlund (2007). Furthermore, the estimation results suggest that the speed of adjustment to the long-run equilibrium marginally differs across the maturity of the underlying instrument, thus supporting the efficient market hypothesis.     

Uncovered interest parity puzzle: does it really exist?

Most studies indicate the violation of the Uncovered Interest Parity (UIP) restrictions, and indeed, there are many who find a statistically significant and negative interest rate differential slope. This finding has now become known in international economics as the UIP puzzle. Using recent data on four major currencies vis-à-vis the US dollar and employing the Generalized Method of Moments (GMM) technique, our estimation results indicate the absence of any relationship between the interest rate differential and the expected change in the exchange rate, rather than the presence of the UIP puzzle.     

Uncovered interest parity in Central and Eastern Europe: Expectations and structural breaks

This paper examines the empirical validity of the hypothesis of uncovered interest parity (UIP) using data from five Central and Eastern European countries with floating exchange rates for the period 2003 to 2014. The analysis includes forward‐looking as well as static expectations and allows for different types of structural break. The variable depicting the deviation from strict UIP is stationary when expectations are forward looking, suggesting that it is not possible to reject the UIP hypothesis with a constant risk premium. The deviation from strict UIP is however typically not stationary when expectations are static, even when structural breaks are incorporated, leading to the rejection of the UIP hypothesis with a constant risk premium. The results underscore the central role of expectations for the UIP hypothesis.     

TESTING UNCOVERED INTEREST PARITY: A CONTINUOUS‐TIME APPROACH*

Nowadays researchers can choose the sampling frequency of exchange rates and interest rates. If the degree of overlap is large relative to the sample size, standard GMM asymptotic theory provides unreliable inferences in uncovered interest parity (UIP) regression tests. We specify a continuous‐time model for exchange rates and forward premia robust to temporal aggregation, unlike existing discrete‐time models. We test the UIP restrictions on the continuous‐time model parameters and propose a novel specification test that compares estimators at different frequencies. Our results based on correctly specified models provide little support for UIP at both short and long horizons.     

Interest differentials and extreme support for uncovered interest rate parity

This paper addresses two findings from the empirical literature testing uncovered interest parity (UIP): (i) more favorable results when interest differentials (IDs) are large and (ii) instability across samples. Simulations demonstrate that explanations of the results using large IDs based on the hypothesis of a “zone of speculative inactivity” are inconsistent with empirical evidence. Furthermore, it is shown that, if agents forecast IDs based on long-run values, coefficient estimates will be unstable if rates of decay in IDs vary significantly and, for ex post UIP to hold, IDs must decay in absolute value. This is consistent with OECD country data.     

The long-run uncovered interest rate parity in view of a trading strategy

Uncovered Interest Rate Parity (UIP) states that bonds in different denomination should produce the same returns if the maturities of the bonds are the same. Given this, if a foreign bond produces a lower holding period return than a home bond of the same maturity, for their remaining lives the same foreign bond ought to produce a return higher than the home bond. A test is designed according to this relationship. With 1 to 6 year interest rate data of U.S., Britain and Germany from 1979 to 2005, our test shows that this relationship is more reliable for 6-year interest rates than the shorter rates in general. This result lends support to the long-run UIP. A trading strategy is developed by utilizing this idea. We show that positive returns can be achieved by the strategy for bonds of longer horizons. This result also serves as indirect evidence of the long-run UIP.     

Uncovered Interest Parity at Long Horizons: Evidence on Emerging Economies*

This paper estimates uncovered interest parity (UIP) at long horizons using bilateral US dollar rates vis‐à‐vis mature economy and emerging market currencies. The paper finds support in favor of UIP for dollar rates vis‐à‐vis major mature economy currencies, but far less against emerging market currencies. There are also signs that political risk and the exchange risk premium help explain the empirical failure of UIP for these latter currencies. This suggests that whether UIP holds depends more on the currency than on the horizon.     

Mean Reversion of Short‐run Interest Rates in Emerging Countries*

In this paper we examine the stochastic behavior of short‐run interest rates in several emerging countries using fractional integration techniques. We allow for a much richer flexibility in the dynamic behavior of the series than the classical representations based on I(0) or I(1) processes. It appears that for Singapore and Thailand nominal interest rates are mean‐reverting, whereas for Mexico, Malaysia, the Philippines, and Korea, the presence of a unit‐root test depends on the assumptions regarding the residuals’ autocorrelation. The results also suggest that uncovered interest parity (UIP) can only hold for two emerging countries. For the other countries, the stabilization policies in the aftermath of the currency crises have led to the rejection of the UIP hypothesis.     

On the Joint Test of the Uncovered Interest Parity and the Ex‐ante Purchasing Power Parity

This study revisits the relation between the uncovered interest parity (UIP), the ex‐ante purchasing power parity (EXPPP) and the real interest parity (RIP) for the UK and Japanese vs US data. The original contribution is on developing some joint coefficient‐based tests, obtained by rewriting the UIP, the EXPPP and the RIP as a set of cross‐equation restrictions in a vector autoregression (VAR) framework. Test results point to a “forward premium” bias in both the UIP and the EXPPP. The latter result is novel in the literature and stems from testing the PPP in expectational terms. Moreover, the results suggest a currency‐dependent pattern for the UIP, contrarily to the EXPPP equation. Finally, it is shown that conditioning the VAR on M3 growth differential has important explanatory power in resolving the aforementioned biases in both the UIP and EXPPP equations for the UK vs US data. At the same time, variables having a strong forward‐looking component (i.e. share prices) help recover a unitary coefficient in the UIP equation.     

Purchasing power parity and uncovered interest parity: The Spanish case

This paper examines whether the purchasing power parity (PPP) hypothesis holds in the long run when traded and non-traded goods are distinguished. Moreover, this hypothesis is analyzed jointly with the uncovered interest parity (UIP). The period from January 1986 to December 1995 was studied using monthly data corresponding to the consumer price index, short- and long-term interest rates, and spot exchange rates for Portugal, France, Italy, Germany, and Great Britain with each relative to Spain. Using Johansen's multi-equational cointegration technique, it was found that PPP does not hold even with the explicit consideration of the distinction between traded and non-traded goods as well as the difference between domestic and foreign interest rates. Furthermore, these two factors generate a systematic deviation between exchange rates and PPP.     

The precise form of uncovered interest parity: A heterogeneous panel application in ASEAN-5 countries

A notable feature of the empirical studies on uncovered interest parity (UIP) is that almost all published papers rely on the approximate form of UIP using substantially the same database of developed economies. It can, therefore, not be ruled out that the refusal of UIP condition is simply the outcome of a misspecification of a commonly used model and an elaborate data snooping process. In order to overcome this specification problem, this paper uses the precise form of UIP and examines its empirical validity based on a sample of ASEAN-5 member countries. Using the heterogeneous panel cointegration tests, our empirical results indicate that the gross domestic return and the uncovered gross foreign return are cointegrated in the long run. The long-run cointegrating coefficients are then estimated using the fully modified OLS (FMOLS) and the dynamic OLS (DOLS) proposed by Pedroni. The estimated long-run coefficients suggest that UIP only holds for Singapore. These results indicate that the Singapore financial market is highly integrated with the US market. As for the other four countries, the precise UIP hypothesis is strongly rejected suggesting that the financial markets in these emerging economies have not fully liberalized and, therefore, limited the international financial market integration. By examining international finance market linkages between ASEAN-5 and the US economy, we provide some policy implications that can be used as guiding tools for financing and investment decisions in ASEAN-5.     

Uncovered interest parity and risk premium convergence in Central and Eastern European countries

This study applies non-linear threshold unit-root test to investigate the non-stationary properties of the uncovered interest parity (UIP) with risk premium for ten Central and Eastern European (CEE) countries. We find that non-linear threshold unit-root test has higher power than linear method suggested by Caner and Hansen (2001) if the true data generating process of risk premium convergence is in fact a stationary non-liner process. We examine the validity of UIP from the non-linear point of view and provide robust evidence clearly indicating that UIP holds true for seven countries. Our findings point out that capital mobility and exchange market efficiency are in these CEE countries with non-linear way.     

Have budget deficits and money growth caused changes in interest rates and exchange rates in Canada?

This paper examines empirically the causal impact of monetary and fiscal policy on exchange rates and interest rates in Canada using a six-by-six vector autoregressive (VAR) model with variable lag structure. The results suggest that changes in the base money and budget deficits have no direct causal effects on exchange rates, a finding consistent with the monetary explanation that exchange rates follow a random walk. Also consistent with the Ricardian equivalence hypothesis, the results reveal no direct effect of budget deficits on interest rates, casting doubts on the crowding-out phenomenon for Canada. In contrast, changes in the base money unidirectionally cause changes in interest rates, implying some support for using interest rates as a key intermediate policy target for the Canadian monetary authorities.     

Non-stationary Interest Rate Differentials and the Role of Monetary Policy

Abstract

The present work deals with a frequently detected failure of the uncovered interest rate parity (UIP) – the absence of bivariate cointegration between domestic and foreign interest rates. We explain the non-stationarity of the interest differential via central bank reactions to exchange rate variations. Thereby, the exchange rate in levels introduces an additional stochastic trend into the system. Trivariate cointegration between the interest rates and the exchange rate accounts for the missing stationarity property of the interest differential. We apply the concept to the case of Turkey and Europe, where we can validate the theoretical considerations by multivariate time series techniques.     

An Incomplete Markets Explanation of the Uncovered Interest Rate Parity Puzzle

A large literature attributes failure of uncovered interest rate parity (UIP) to the existence of a time‐varying risk premium. This paper presents a mechanism in a simple two‐country two‐good endowment economy with incomplete markets that generates sizeable deviations from UIP. In a parameterization where international wealth effects are important, liquidity constraints on an internationally traded bond and agents’ strong resulting precautionary motives successfully generates a time‐varying risk premium: countries that have accumulated large outstanding external positions have, being closer to the constraints, stronger precautionary motives and their asset carries a risk premium.     

Sustainability of Monetary-cum-Exchange Rate Policy in China

This paper theoretically considers the long-run sustainability of China’s monetary-cum-exchange rate policy under the impossible trinity. Two different models are examined: One sterilizes current net foreign assets (NFAs) and the other focuses on NFAs realized in the previous period. Under the de facto opening of financial flows, sterilization yields a negative risk premium in uncovered interest parity (UIP) that triggers a feedback increase among capital inflows. Here, stability depends on the magnitudes and the combination of structural and policy parameters. It is shown that if current capital inflows are sterilized, the monetary-cum-exchange rate policy in China offers a sustainable solution for exchange rates that are relatively stringently managed. However, such a solution can be obtained for relatively flexible or moderately managed rates if sterilization policy is implemented on the previous period’s inflows.     

Monetary Policy Regime Shifts and Uncovered Interest Parity Revisited: The Euro–US Dollar Exchange Rate

ABSTRACT

To explore possible sources of the well-documented uncovered interest parity (UIP) violation in the foreign exchange market, this paper scrutinizes structural changes in monetary reactions to inflationary pressure in the conventional approaches to nominal exchange rate and examines how this small but important change has an effect on the empirical implications of the UIP condition. In addition to some salient features found in the euro exchange rate, by introducing occasional monetary policy regime shifts into an otherwise standard open-economy dynamic general equilibrium model, we found some important findings that potentially help better understand exchange rate dynamics. During the entire sample period, 1999:M1–2014:M8, exchange rate disconnect puzzle still exists. However, sub-sample analysis suggests that relatively passive monetary reaction implying less frequent intervention by monetary authority tends to be more consistent with the UIP relation. Simulation results support the empirical regularities.