On the Efficiency of Capital Markets ? A Dynamic Analysis of the Term Structure of Interest Rates in Britain

Abstract

This paper investigates the uncovered interest parity hypothesis (UIP) in an unusual way. A common prediction from theoretical models is that inefficient capital markets cause greater volatility of the observed time series. We provide empirical evidence on the efficiency of capital markets using a time domain approach. From this model we derive the dynamic properties in the time and frequency domain. Furthermore, we show how to conduct a frequency analysis on a reduced sample of data, without the latter being ruled out by the large sample requirements of direct spectral estimation. We also show, in particular, how this can be done for time-varying models resulting in time-varying spectra. We use our techniques to examine the changing stability of the relationship between British, German, and US interest rates during and following the ERM crisis of 1992/3. It turns out that UIP does not hold and that the risk premium plays a crucial role in the agents' behaviour.