Currency Regimes and Weak Interest Rate Parity

Abstract

We consider the presence of regimes in currency markets and their implications for interest rate parity. A weak form of interest rate parity is postulated and tested which assumes that the hedged risk premiums are identical within each regime across currencies. Both the in-sample (January 2002 - December 2004) and the out-of-sample (January 2005 - December 2007) daily data support weak interest rate parity. Furthermore, using the Federal Exchange Rate Index as a proxy of the currency market portfolio and T-Bills as the risk free asset, we find strong evidence that the weak interest rate parity hypothesis is consistent with standard portfolio equilibrium theory. The similarity between the benchmark and the implied equilibrium portfolio provides strong evidence that regime switching with weak interest rate parity is appropriate for modeling currency returns.

Keywords: Regime, Switching, Weak Interest Rate Parity

JEL Classification: B23, C11, C61, G13, D90