Uncovered Interest Parity Revisited

Abstract

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 the typical finding, the results are rather favorable to UIP.

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

“…In this case, short-and long-term bond markets are segmented from each other (Lim and Ogaki, 2003). A finding consistent with this approach is provided by Alexius and Sellin (2001). They show that short-horizon holding period returns on long-term bonds do not exhibit bias in predicting short-horizon exchange rate changes.…”

“…They obtain a positive coefficient on the interest differential of 0.596, still statistically different from the value of unity, but at least positive. Similarly, Alexius (2001) examines 14 long-term bond rates of varying maturities for the 1957e1997 period, also drawn from IFS. She too finds coefficient estimates much closer to unity.…”

The Forward Premium Puzzle Only Emerges Gradually

“…Some recent evidence shows that the appearance of this puzzle depends significantly on the observed maturity horizon of financial products. Alexius (2001), Chinn and Meredith (2004) and Chinn (2006) focus on the related UIP condition (UIP) at the multi year maturity level. Using five and ten year zero-coupon yields, they find that the rejection of the UIP becomes less decisive if the maturity horizon increases.…”

“…Using five and ten year zero-coupon yields, they find that the rejection of the UIP becomes less decisive if the maturity horizon increases. 1 Chaboud and Wright (2005) reconsider the UIP hypothesis for the shortest maturity horizon possible at the intra day level. They find results that are supportive for the expectations hypothesis over very short maturity horizons up to a day.…”

Macro Approaches to Foreign Exchange Determination

“…One should expect better performance at the long horizon because Chinn and Meredith (2004) and Alexius (2001) find that UIP holds better at long horizons than short.…”