Does the Theory of Uncovered Interest Rate Parity Hold for Sri Lanka

Abstract

Interest rates and exchange rates are considered to be one of the most discussed areas under International Finance. When considering the main theories that explore on these two variables, Uncovered Interest Rate Parity (UIP) states that the interest rate differential is an unbiased predictor of the spot exchange rate changes. The impact on investors’ attitude is that they would be indifferent towards the returns on domestic and foreign assets denominated in same currency thereby eliminating any short term arbitrage profits. Studies based on the relationship between these two variables are rare for developing countries like Sri Lanka. Therefore in order to bridge that gap identified through search for literature, this study is focused on testing UIP for Sri Lanka. Autoregressive Distributed Lags method was employed to test the UIP. Monthly data on exchange rates and three month risk free interest rates with regard to the selected major external trader, USA for the period from 2001-2014 were used for this purpose. The findings reveal that there is no evidence to prove the existence of UIP either in the long run or in the short run for the US$ compared against to the Sri Lankan Rupee.

Keywords: Interest Rates, Exchange Rates, Uncovered Interest Rate Parity (UIP), Unit root tests, Autoregressive Distributed Lags (ARDL) Model

JEL Classification: F31, F41, P45