The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets

Abstract

This paper examines several new empirical findings in the study of uncovered interest parity. It reviews recent developments in the study of long-horizon interest parity regressions, the implications of relaxing the rational expectations methodology and the characteristics of results pertaining to the non-G7 currencies, including those in less developed economies. In brief, the evidence against uncovered interest parity in the current floating rate era is not as great as is commonly thought, although it is still true that for the major currencies, the short-term interest differential remains a biased predictor of ex post changes in the exchange rate.

Testing the UIP Hypothesis-Using Data from Partially Dollarized Developing Countries

“…This same pattern holds in Uganda as well. This finding is consistent with the results in Chinn (2006).…”

“…In fact, UIP holds better in Bolivia than even Poghosyan et al (2008) have found for Armenia. He also finds that, unlike Chinn (2006), the bias increases as the maturity horizon increases. In particular, the estimated beta ranges from about 0.31 at the one-month horizon to 0.21 at the three-month horizon and 0.10 at the 12-month horizon.…”

“…In fact, UIP holds better in Bolivia than previous studies show in developed and emerging markets. He also finds that, unlike Chinn (2006), the bias increases as the maturity horizon increases. In addition, time varying risk premia, deviations from rational expectations, and the peso problem partially account for the observed deviation from the UIP hypothesis.…”

“…For instance, Chinn (2006) estimated an equation similar to 3 above for the exchange rate between the U.S. dollar and currencies of other G 7 countries (U.K., France, Germany, Japan, Italy, and Canada) for the period 1980-2000. He finds that the estimated beta is less than zero in all cases except the exchange rate between Italian Lira and the U.S. dollar and the average coefficient for the group is -0.8.…”

Macro Approaches to Foreign Exchange Determination

“…Alternatively, interest differentials do not predict either well, or the direction, of subsequent exchange rate changes implied by interest rate parity. Chinn (2006) highlight these well known facts. One way to explain the failure of uncovered interest parity combined with rational expectations (sometimes called the unbiasedness hypothesis)…”