Interest rate determination across the maturity spectrum in a small open economy: the case of Switzerland

Abstract

According to UIP (uncovered interest parity) the domestic interest rate for a given maturity equals the interest rate on the comparable asset denominated in foreign currency plus the expected rate of depreciation of the local against the foreign currency. In this original and most simple form the hypothesis is not only based on the absence of restrictions on international capital movements, but also builds on strong assumptions of risk neutrality and homogeneity of exchange rate expectations. The measurement of exchange rate expectations has already posed problems in the early stages of research: the forward premium turned out to be an inadequate predictor of actual and expected exchange rate changes. The addition of a constant risk premium factor to the strict version of UIP did not help much to resolve the issue, so a time-varying risk premium has become a favoured supplementary variable for explaining interest rate differentials.