Uncovered Interest Rate Parity and the Expectations Hypothesis of the Term Structure: Empirical Results for the US and Europe

Abstract

If interest rates are considered to be integrated of order one (I(1)) uncovered interest rate parity (UIP) implies that domestic and foreign nominal interest rates should be integrated with cointegrating vector (1,-1). On the other hand, if the expectations hypothesis of the term structure (EHT) is true another equilibrium condition can be derived, namely that domestic short- and long- term interest rates should cointegrate with the vector (1,-1). Thus UIP and EHT imply that three cointegrating vectors should exist in the four dimensional system of short- and long-run domestic and foreign interest rates. These hypotheses are tested with monthly observations of short- and long-term European and US interest rates for the period 1994(1) to 2001(12). It is found that only one cointegrating relation exists between these four interest rates. It is a linear combination between the spread in Euroland and the spread in the US. A vector error correction model for the spreads gives further insights into the dynamic relations between the interest rates in the US and Euroland.KeywordsUncovered interest rate parityexpectations hypothesiscointegrationvector error correction modelling