Uncovered Interest Parity (UIP) in the Mean and Variance of the ILS/USD Exchange Rate

Abstract

This paper examines the simultaneous short-term relationships between the ILS/USD exchange rate and domestic interest rates, the foreign interest rates and the interest-rate differentials along the term structure of interest rates. The test is performed using the ARCH (autoregressive conditional heteroskedasticity) procedure of two variables with a bi-variate threshold ARCH (BV-TARCH) that incorporates a set of equations describing the short term relationship between the exchange rate and interest rates. This procedure enables us to analyze the effect of each of the variables on the other, both the first moment, i.e., the expectation, and the second moment, the conditional variance. It also enables us to identify asymmetry in the effects of shocks and their autoregressive effects. The second section of the paper examines the Uncovered Interest Parity (UIP) hypothesis along the interest-rate differential term structure. The analysis of the results of the procedure used on weekly data for the years 1999-2005 shows that in the mean equation the exchange rate has a positive effect on the long-term domestic interest rates and on the interest-rate differential, but the reverse relationship does not hold. On the other hand, in the conditional variance equation, no cross-relationship was found between the exchange rate and the interest rates or the interest-rate differential. The conditional correlation of the error matrix of these variables and its level of significance rose with the term structure. Examination of the UIP during the sample period shows that changes in the interest-rate differential, particularly for the long term, predicted the changes in the exchange rate better than did the differential itself. These findings can be explained by the significant contraction of the interest-rate differential that occurred during the sample period compared with the small depreciation reflected by the ILS/USD exchange rate in that period.