Testing for Uncovered Interest Parity Conditions in a Small Open Economy: A State Space Modelling Approach

33 Pages Posted: 8 Jul 2021

See all articles by Guna Raj Bhatta

Guna Raj Bhatta

School of Business, Faculty of Business and Law, University of Wollongong

Rabindra Nepal

School of Accounting, Economics, and Finance, University of Wollongong

Charles Harvie

University of Wollongong

Kankesu Jayanthakumaran

University of Wollongong - Department of Economics

Date Written: July 5, 2021

Abstract

This is the first study to apply the Kalman filter analysis based on state space modelling to test for the existence of the uncovered interest parity (UIP) condition and simulate the risk premium between the pegged currencies of Nepal and India. We find significant evidence that the UIP condition does not hold in Nepal. Simultaneously, a negative risk premium of about 12 per cent exists on average based on our model calibration using the monthly and the annual time-series data. The Kalman filter simulations further confirm our modelling assumptions that the ordinary least squares-based risk premium estimation is substantially biased in both sign and magnitude. The presence of a negative risk premium provides three key policy implications: a preference to hold foreign assets by residents, the expectation of a future currency devaluation, and obstacles to attracting foreign deposits.

Keywords: uncovered interest parity, State Space Model, Kalman filter, risk premium

JEL Classification: E43, F33

Suggested Citation

Bhatta, Guna Raj and Nepal, Rabindra and Harvie, Charles and Jayanthakumaran, Kankesu, Testing for Uncovered Interest Parity Conditions in a Small Open Economy: A State Space Modelling Approach (July 5, 2021). CAMA Working Paper No. 56/2021, Available at SSRN: https://ssrn.com/abstract=3880204 or http://dx.doi.org/10.2139/ssrn.3880204

Guna Raj Bhatta

School of Business, Faculty of Business and Law, University of Wollongong ( email )

Northfields Avenue
Wollongong, New South Wales 2522
Australia

Rabindra Nepal (Contact Author)

School of Accounting, Economics, and Finance, University of Wollongong ( email )

Northfields Avenue
Wollongong, New South Wales 2522
Australia

Charles Harvie

University of Wollongong ( email )

Wollongong, NSW 2522
Australia

Kankesu Jayanthakumaran

University of Wollongong - Department of Economics ( email )

Northfields Avenue
Wollongong, New South Wales 2522
Australia

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