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.     

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.     

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 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.     

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.     

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.     

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.     

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.     

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.     

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.     

Volatility trade-offs in exchange rate target zones

The volatility trade-offs (i.e. the negative relationships between exchange rate variability and the interest rate differential) exhibited in the Krugman [Krugman, P. (1991). Target zones and exchange rate dynamics. Quarterly Journal of Economics, 106, 669–682.] model depend on the assumption of uncovered interest rate parity (UIP). However, the bands for several economies in Latin America and Eastern Europe are substantially different from those within the European Monetary System (EMS), in that their parity relationship deviates from UIP and volatility trade-offs do not exist. This paper develops a graphical exposition and uses it to show that the degree of capital mobility may serve as a plausible vehicle to explain the empirical evidence found in Krugman's regime of exchange rate target zones. Based on a Fleming-type stochastic macro model, we find that when capital mobility is relatively low, exchange rate variability exhibits a positive relationship with the interest rate differential. This result can be regarded as a possible way of resolving the conflicting outcomes between Krugman's prediction and existing empirical observations.     

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.     

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.     

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.     

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.     

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.     

HUNGARY'S EUROZONE ENTRY DATE: WHAT DO THE MARKETS THINK AND WHAT IF THEY CHANGE THEIR MINDS?

This article investigates the potential impact of a shift in market expectations about a country's eurozone entry date on long-term yields and the spot exchange rate in a simple uncovered interest parity (UIP) framework. The results suggest that the size of the reactions depend on how far the entry date is postponed, how far current inflation is from the Maastricht-satisfying level, and whether the credibility of the central bank's target inflation path is sensitive to changes in the expected entry date. In the empirical part, the authors apply the framework for Hungary and draw some policy conclusions for the timing of ERM II entry. (JEL E44 , E52 , F33 )     

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.     

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.     

THE REAL INTEREST RATE DIFFERENTIAL: INTERNATIONAL EVIDENCE BASED ON NON-LINEAR UNIT ROOT TESTS

This paper aims at testing international parity conditions by using non-linear unit root tests advocated by Kapetanios et al . (2003, KSS). Results from the KSS tests based on 17 countries (G7 and 10 Asian countries) overwhelmingly show that the adjustment of real interest rates towards real interest rate parity (RIP) follows a non-linear process except for the Taiwan, Hong Kong and Philippines relationships with both the USA and Japan. Overall, the empirical results are in favour of RIP using the USA and Japan as the centre countries but only if non-linearities are accounted for in the data-generating process. Our findings confirm that interest rate differentials, like the real exchange rates reported in recent literature, display a non-linear mean reversion process.