Assessing the Applicability of Uncovered Interest Parity in the South Asian Frontier Financial Markets

Abstract

Purpose: The purpose of this research is to establish whether, the Uncovered Interest Parity (UIP) condition exists in Bangladesh, Pakistan, and Sri Lanka, categorized as the South Asian frontier financial markets.Design/Methodology/Approach: The research uses the deductive approach. The data was collected from International Monetary Fund Statistics. The data set used consists of monthly data from March 2010 to April 2020. Interest rate differential was employed as the independent variable in this study, with the foreign currency exchange rate differential as the dependent variable. The researcher used the Cointegration model and the Vector Error Correction Model to analyze the data to measure the long-term and short-term impact respectively.Findings: It was found that, interest rate differential had a statistically insignificant negative relationship with the exchange rate differential in all three countries both in the short and long run. The overall test results show that the rejection of UIP hypothesis within the given time frame in South Asian frontier financial markets confirming the previous findings relating to practical situation of UIP condition.Originality: This article reviews the rejection of UIP condition in Bangladesh, Pakistan and Sri Lanka, categorized as the South Asian frontier financial markets. In a single paper it provides both short-term and long-term rejection of UIP. The rejection of the UIP condition implies that there is a possibility for an arbitrage opportunity.Future Direction: The future research can assess the applicability of UIP for a larger sample and different data analysis techniques such as Generalized Method of Moment.