Irving Fisher, the UIP Puzzle and the 'Peso Problem'

34 Pages Posted: 5 Mar 2007

See all articles by Rachel A.J. Pownall

Rachel A.J. Pownall

Tilburg University - Department of Finance; Maastricht University - Department of Finance

Kees C. G. Koedijk

Tilburg University - Department of Finance

James R. Lothian

Gabelli School of Business, Fordahm University; National Bureau of Economic Research (NBER)

Ronald Mahieu

Tilburg University - Center for Economic Research, Econometrics and Finance Group; TiasNimbas Business School

Date Written: March 2007

Abstract

In this paper, we first review Irving Fisher's seminal work on UIP and on the closely related equation linking interest rates and inflation relation. We go on to re-examine the performance of UIP since the advent of floating exchange rates in the 1970s. Like Fisher a century ago, we find that the failures of UIP are tied in with individual episodes in which errors surrounding exchange-rate expectations have been persistent but in the end transitory. We see evidence of this behavior both in the changed coefficients estimates from rolling regressions. We also find considerable commonality in deviations from UIP and PPP suggesting that these deviations are both driven by a common factor as the forecasting errors in exchange rates. Using a dynamic latent factor model we find that deviations from UIP are almost completely due to forecasting errors in exchange rates. Once the variation in the size of the forecasting errors is taken into account we find empirical support of a unitary value for the implied beta in the Fama regression. Using a number of countries we find unanimous support that deviations from UIP are driven by errors made in forecasting exchange rates, a result which we attribute to Irving Fisher who first mentioned this a century to date.

Keywords: UIP, Irving Fisher, Expectations formation, small-sample problems

JEL Classification: F31, B1

Suggested Citation

Pownall, Rachel Ann Jane and Koedijk, Kees G. and Lothian, James R. and Mahieu, Ronald J., Irving Fisher, the UIP Puzzle and the 'Peso Problem' (March 2007). Available at SSRN: https://ssrn.com/abstract=968246 or http://dx.doi.org/10.2139/ssrn.968246

Rachel Ann Jane Pownall

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Maastricht University - Department of Finance ( email )

Maastricht, 6200 MD
Netherlands

Kees G. Koedijk

Tilburg University - Department of Finance ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 4663048 (Phone)
+31 13 4662052 (Fax)

James R. Lothian (Contact Author)

Gabelli School of Business, Fordahm University ( email )

113 West 60th Street
New York, NY 10023
United States
212-636-6147 (Phone)
212-765-5573 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Ronald J. Mahieu

Tilburg University - Center for Economic Research, Econometrics and Finance Group ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2430 (Phone)
+31 13 466 3280 (Fax)

HOME PAGE: http://center.uvt.nl/staff/mahieu/

TiasNimbas Business School ( email )

Warandelaan 2
Tilburg, North-Brabant 5071HS
Netherlands

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