Abstract
We exploit the link between deviations from uncovered interest rate parity (UIP), long-run relative purchasing power parity (PPP), and deviations from real rate equality, to develop more powerful tests of the predictive power of real exchange rates for excess currency returns. Assuming long-run relative PPP, we obtain much stronger evidence of predictability than if we test UIP in isolation. The real exchange rate is also the main driver of in nite-horizon UIP deviations. Based on a present value representation, we attribute a statistically signi cant 93% of the variability of the real exchange rate to deviations from UIP.
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