A Multivariate GARCH in Mean Approach to Testing Uncovered Interest Parity: Evidence From Asia-Pacific Foreign Exchange Markets

The Quarterly Review of Economics and Finance, Volume 41, Issue 4, Pages 441-460, Winter 2001.

Posted: 28 Feb 2021

See all articles by Chu-Sheng Tai

Chu-Sheng Tai

Texas Southern University - Department of Accounting and Finance

Date Written: January 2, 2001

Abstract

The existence of time-varying risk premia in deviations from uncovered interest parity (UIP) is investigated based on a conditional capital asset pricing model (CAPM) using data from four Asia-Pacific foreign exchange markets. A parsimonious multivariate generalized autoregressive conditional heteroskedasticity in mean (GARCH-M) parameterization is employed to model the conditional covariance matrix of excess returns. The empirical results indicate that when each currency is estimated separately with an univariate GARCH-M parameterization, no evidence of time-varying risk premia is found except Malaysian ringgit. However, when all currencies are estimated simultaneously with the multivariate GARCH-M parameterization, strong evidence of time-varying risk premia is detected. As a result, the evidence supports the idea that deviations from UIP are due to a risk premium and not to irrationality among market participants. In addition, the empirical evidence found in this study points out that simply modeling the conditional second moments is not sufficient enough to explain the dynamics of the risk premia. A time-varying price of risk is still needed in addition to the conditional volatility. Finally, significant asymmetric world market volatility shocks are found in Asia-Pacific foreign exchange markets.

Keywords: UIP, Time-varying risk premium, CAPM, Multivariate GARCH-M

JEL Classification: C32, F31, G12

Suggested Citation

Tai, Chu-Sheng, A Multivariate GARCH in Mean Approach to Testing Uncovered Interest Parity: Evidence From Asia-Pacific Foreign Exchange Markets (January 2, 2001). The Quarterly Review of Economics and Finance, Volume 41, Issue 4, Pages 441-460, Winter 2001., Available at SSRN: https://ssrn.com/abstract=3758652

Chu-Sheng Tai (Contact Author)

Texas Southern University - Department of Accounting and Finance ( email )

United States

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