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.     

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.     

Uncovered Interest Parity Revisited

A standard empirical finding in international finance is that countries with high nominal interest rates experience appreciations of their currencies, in contrast to predictions based on uncovered interest parity (UIP). However, tests of UIP have almost exclusively relied on data on short-term interest rates. In this paper, UIP is tested on long-term government bond yields. Since the presence of coupon payments induces a measurement error between the observed data and true returns, several different proxies for the latter are constructed. Furthermore, instrumental variable techniques are used. In contrast to thetypical finding, the results are rather favorable to UIP.     

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.     

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.     

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.     

Purchasing Power Parity and Interest Parity in the Laboratory

This paper analyses purchasing power parity and uncovered interest parity in the laboratory. It finds strong evidence that purchasing power parity, covered interest parity, and uncovered interest parity hold. Subjects are endowed with an intrinsically useless (green) currency that can be used to purchase another useless (red) currency. Green goods can be bought only with green currency, and red goods can be bought only with red currency. The foreign exchange markets are organised as call markets. In the treatment analysing purchasing power parity, the price of the red good varies. In a second treatment, the interest rate on red currency varies. In a third treatment, the interest rate on red currency varies, and the price of the red good is random.     

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.     

Forward-premium puzzle: is it time to abandon the usual regression?

The forward premium puzzle is usually evidenced by the rejection of the null hypothesis in the uncovered interest parity (UIP) regression. Because this parity need only hold in a risk-neutral world, a risk adjustment term is missing from the equation if speculation in foreign exchange markets is risky. We deal with this issue following the literature which assumes that discounted returns on foreign government bonds are log-normal, so we can linearize the Euler pricing equations (in level) and obtain a modified UIP system for which the risk adjustment term is obtained by applying to the pricing kernel-based relations a generalized autoregressive conditional heteroscedasticity-in-mean model. However, here we innovate by adopting a methodology which differs from all these related works. We construct and use a stochastic discount factor that does not depend on a specific model, by residing in the space of returns which we extract from the data by simply imposing the orthogonality restrictions represented by the Euler equations. So, we devise a purely statistical pricing kernel that performs well in in-sample level equations. Somewhat disappointingly, the risk premium inclusion in the conventional regression changes neither the significance nor the magnitude of the forecasting power of the forward premium for most currencies we study. The contrasting performance of the tests in level and in logs suggests that linearization may be to blame.     

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.     

The Impact of 2007/08 Financial Crisis on the Stability and Enlargement of the EMU

Before 2007/08, the European Monetary Union (EMU) was expected to be enlarged on schedule, but the European sovereign debt problem, triggered by the exogenous US sub‐prime crisis, not only has revealed the EMU's fiscal coordination failure, but also has weakened regional financial integration. The stagnation of financial integration will therefore increase the cost of sustaining a monetary union, which in turn slows EMU enlargement and ruins the reputation of the euro. This paper aims to measure the damage to financial integration and to provide a more precise answer on real interest rate parity (RIP) convergence. Our estimation indicates that RIP between the EMU and some accession candidates is still valid after the interruptions of the financial crises. However, convergence of real interest rates cannot be achieved until 2030. This implies the EMU authority must strengthen regional financial integration to solidify the EMU and then be able to re‐start enlargement.     

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.     

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.     

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.     

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.     

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.     

Convergence to Purchasing Power Parity at the Commencement of the Euro*

We investigate convergence towards purchasing power parity (PPP) within the eurozone and between the eurozone and its main partners using panel data methods. We find strong rejections of the unit‐root hypothesis, and therefore evidence of PPP, in the eurozone for different numéraire currencies, as well as in the eurozone plus the United States with the dollar as the numéraire currency, starting between 1996 and 1999. The process of convergence towards PPP, however, begins earlier, following the currency crises of 1992 and 1993, adoption of the Maastricht Treaty, and official completion of the Single Market.     

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.     

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.     

Measuring the end of the European financial crisis

In 2013 it was declared that ‘the eurozone crisis is over’. However, in fact, the series of financial crises since 2008 may have interrupted the process of EMU enlargement, which in turn triggered a continuing crisis of confidence in the euro. In this paper we extend the sigma‐convergence test to provide a more precise understanding of real interest rate parity (RIP) convergence. On the basis of this, we predict the timing for eliminating the cost of economic asymmetric shocks. Our estimation indicates the RIP among EMU members and accessions were still valid after the disruptions of the 2008 financial crisis. However, the situation has been even worse since the 2010 European sovereign debt crisis, and ceteris paribus, symmetry cannot be achieved without further policy actions. This implies that the EMU authority must do its best to strengthen symmetry and thereby solidify the EMU, at which point it will be better able to re‐start the process of enlargement.