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Uncovered Interest Rate Parity over the Past Two Centuries

James R. Lothian

Fordham University Schools of Business; National Bureau of Economic Research (NBER)

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

June 12, 2003

Uncovered interest rate parity (UIP) is one of three key theoretical relations used in analytical work in both international finance and international monetary economics. The problem, however, is that UIP does not seem to hold up well empirically. In this paper, we argue that the failures of UIP that have been so widely documented are a coincidence of two empirical artifacts: (1) the unique sample period of the 1980s and (2) The noise induced by small UIP deviations. We control for these empirical artifacts by constructing an ultra long time series that spans two centuries and by running regressions conditional on large deviations from UIP. We find that traditional regressions yield positive slope estimates over the whole sample period and become negative only when the sample is dominated by the period of 1980s. We argue that the negative estimates during this sample period are mainly the result of a failure of expectations to adjust quickly to the regime changes in monetary policy that took place in both the United Kingdom and the United States. We also find that large interest rate differentials have significantly stronger forecasting powers for currency movements than small interest rate differentials. Finally, a historical account of expected and realized regime changes further illustrates how the expectation hypothesis holds over the very long haul but can be deviated from for a long period of time due to slow adjustment of expectations to actual regime changes or to anticipations for extended periods of regime changes or other big events that never materialize.

Number of Pages in PDF File: 39

Keywords: Uncovered interest rate parity,expectation hypothesis, regime changes, small sample problem, Peso problem, extreme sampling

JEL Classification: G12, F31

working papers series

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Date posted: September 2, 2004  

Suggested Citation

Lothian, James R. and Wu, Liuren, Uncovered Interest Rate Parity over the Past Two Centuries (June 12, 2003). Available at SSRN: http://ssrn.com/abstract=585462 or http://dx.doi.org/10.2139/ssrn.585462

Contact Information

James R. Lothian
Fordham University Schools of Business ( email )
113 West 60th Street
New York, NY 10023
United States
212-636-6147 (Phone)
212-765-5573 (Fax)

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Liuren Wu (Contact Author)
City University of New York, CUNY Baruch College - Zicklin School of Business ( email )
One Bernard Baruch Way
Box B10-225
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)
HOME PAGE: http://faculty.baruch.cuny.edu/lwu/
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