Revisiting Uncovered Interest Rate Parity: Switching Between UIP and the Random Walk
Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)
Tilburg University - Center for Economic Research, Econometrics and Finance Group; Eindhoven University of Technology (TUE) - Department of Industrial Engineering and Innovation Sciences
In this paper, we examine in which periods uncovered interest rate parity was likely to hold. Empirical research has shown mixed evidence on UIP. The main finding is that it doesn't hold, although some researchers were not able to reject UIP in periods with large interest differentials or high volatility. In this paper we introduce a switching regime framework in which we assume that the exchange rate can switch between a UIP regime and a random walk regime. Our empirical results provide evidence that exchange rate movements were consistent with UIP over some periods, but not all. Consistent with the existing literature we also show that in periods with large interest differentials or increased exchange rate volatility, the exchange rate is more likely to follow UIP.
Number of Pages in PDF File: 19
Keywords: Exchange rates, Uncovered interest rate parity, Markov switching
JEL Classification: F31working papers series
Date posted: January 3, 2007
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