Uncovered Interest Parity Condition Research Articles

CHEER and markets’ integration: evidence from selected East Asian economies

PurposeThis paper aims to investigate markets’ integration using the capital enhanced equilibrium exchange rate (CHEER) model for seven, highly competitive, East Asian countries.Design/methodology/approachThe sample consists of monthly observations, whereas unit root and cointegration techniques with structural shifts have been used.FindingsThe evidence shows that the weak form of the CHEER approach holds for Malaysia and Thailand. For China, Japan, Korea, Singapore and Taipei, only the uncovered interest parity condition is validated, implying capital markets integration. In contrast, for these five countries, the results indicate absence of goods’ markets integration. This outcome can be attributed to the impact of quite high non-tariff barriers and the Balassa–Samuelson effect.Originality/valueTo the best of the author’s knowledge, this is the first study that investigate markets’ integration in several East Asian economies, using the CHEER approach and more accurate price indices.

Uncertainty and the uncovered interest parity condition: How are they related?

Uncertainty and the uncovered interest parity condition: How are they related?

Assessing the Applicability of Uncovered Interest Parity in the South Asian Frontier Financial Markets

Purpose: The purpose of this research is to establish whether, the Uncovered Interest Parity (UIP) condition exists in Bangladesh, Pakistan, and Sri Lanka, categorized as the South Asian frontier financial markets.Design/Methodology/Approach: The research uses the deductive approach. The data was collected from International Monetary Fund Statistics. The data set used consists of monthly data from March 2010 to April 2020. Interest rate differential was employed as the independent variable in this study, with the foreign currency exchange rate differential as the dependent variable. The researcher used the Cointegration model and the Vector Error Correction Model to analyze the data to measure the long-term and short-term impact respectively.Findings: It was found that, interest rate differential had a statistically insignificant negative relationship with the exchange rate differential in all three countries both in the short and long run. The overall test results show that the rejection of UIP hypothesis within the given time frame in South Asian frontier financial markets confirming the previous findings relating to practical situation of UIP condition.Originality: This article reviews the rejection of UIP condition in Bangladesh, Pakistan and Sri Lanka, categorized as the South Asian frontier financial markets. In a single paper it provides both short-term and long-term rejection of UIP. The rejection of the UIP condition implies that there is a possibility for an arbitrage opportunity.Future Direction: The future research can assess the applicability of UIP for a larger sample and different data analysis techniques such as Generalized Method of Moment.

In Search of Dominant Drivers of the Real Exchange Rate

Abstract We uncover the major drivers of macro aggregates and the real exchange rate at business cycle frequencies in Group of Seven countries. The estimated drivers of key macro variables resemble each other and account for a modest fraction of the real exchange rate variances. Dominant drivers of the real exchange rate are orthogonal to main drivers of business cycles, generate a significant deviation of the uncovered interest parity condition, and lead to small movements in net exports. We use these facts to evaluate international business cycle models accounting for the dynamics of both macro aggregates and the real exchange rate.

The portfolio balance channel of capital flows and foreign exchange intervention in a small open economy

In this paper we extend a new Keynesian small open economy model with a segmented financial market featuring financial intermediaries as in Itskhoki and Mukhin (2021). The former ingredients generate deviations from the uncovered interest parity (UIP) condition. More precisely, the portfolio decisions of financial intermediaries add a time varying risk-premium element to the traditional UIP that depends on foreign exchange intervention (FXI) and FX orders by foreign investors. We present closed form solutions for optimal FXI. Additionally, we analyse the effectiveness of different FXI rules commonly discussed across policymakers. Our findings are as follows: (i) FXI rules can improve welfare in presence of the portfolio balance channel; (ii) under a general parametrization, fundamental shocks can trigger an inefficient path for the exchange rate; (iii) optimal policy calls for leaning against the wind to portfolio flow shocks and leaning with the wind to fundamental shocks; (iv) the effectiveness of FXI rules depends on the frequency and nature of the shocks and parameters characterizing the economy.

In Search of Dominant Drivers of the Real Exchange Rate

We uncover the major drivers of macro aggregates and the real exchange rate at business cycle frequencies in Group of Seven countries. The estimated main drivers of key macro variables resemble each other and account for a modest fraction of the real exchange rate variances. Dominant drivers of the real exchange rate are orthogonal to main drivers of business cycles, generate a significant deviation of the uncovered interest parity condition, and lead to small movements in net exports. We use these facts to evaluate international business cycle models accounting for the dynamics of both macro aggregates and the real exchange rate.

Testing for the uncovered interest parity condition in a small open economy: A state space modelling approach

Do interest rate differentials smoothly mirror the changes in the exchange rate between a small open economy and a large emerging market economy? The literature provides conflicting views on the validity of the uncovered interest parity condition (UIP), including its size and factors influencing the risk premium. We examine the validity of the UIP condition between Nepal and India using time-series data covering the period 1989 – 2019. A state space modelling approach based on the Kalman filter analysis is applied to simulate the risk premium. We find that the UIP condition does not hold for the Nepalese Rupee. A time-varying persistent negative risk premium that dominantly explains interest rate differentials is, instead, found. These findings imply that Nepalese residents prefer to hold foreign assets and continually expect future devaluations of the domestic currency. These present obstacles to developing domestic financial markets and the implementation of a market oriented monetary policy.

In Search of Dominant Drivers of the Real Exchange Rate

We uncover the major drivers of each macroeconomic variable and the real exchange rate at the business cycle frequency in G7 countries. In each country, the main drivers of key macro variables resemble each other and none of those account for a large fraction of the real exchange rate variances. We then estimate the dominant driver of the real exchange rate and find that (i) the shock is largely orthogonal to macro variables and (ii) the shock generates a significant deviation of the uncovered interest parity condition. We analyze international business cycle models that are consistent with our findings.

Non-rational beliefs in an open economy

This paper proposes a new theory of exchange rate determination. Under arbitrary beliefs, the exchange rate is determined by an equilibrium restriction which we call the generalized no-arbitrage condition. The pricing function predicts endogenous departures from the conventional rational expectations uncovered interest parity condition. In an empirical open-economy model with learning, using Canadian and United States data, we evaluate whether learning can account for exchange rate dynamics and reduce reliance on exogenous risk-premium shocks to explain departures from uncovered interest parity. Reminiscent of Justiniano and Preston (2010a), we find learning dynamics help explain the persistence and volatility of exchanges rates but generate counter-factual predictions on international macroeconomic comovement.

Testing for Uncovered Interest Parity Conditions in a Small Open Economy: A State Space Modelling Approach

This is the first study to apply the Kalman filter analysis based on state space modelling to test for the existence of the uncovered interest parity (UIP) condition and simulate the risk premium between the pegged currencies of Nepal and India. We find significant evidence that the UIP condition does not hold in Nepal. Simultaneously, a negative risk premium of about 12 per cent exists on average based on our model calibration using the monthly and the annual time-series data. The Kalman filter simulations further confirm our modelling assumptions that the ordinary least squares-based risk premium estimation is substantially biased in both sign and magnitude. The presence of a negative risk premium provides three key policy implications: a preference to hold foreign assets by residents, the expectation of a future currency devaluation, and obstacles to attracting foreign deposits.

Testing deviations from PPP and UIP: evidence from BRICS economies

PurposeThis paper aims to investigate the interrelations between purchasing power parity (PPP) and uncovered interest parity (UIP) in BRICS economies, namely, Brazil, Russia, India, China and South Africa, by checking the validity of the capital-enhanced equilibrium exchange rate (CHEER) approach. Further, this study tests whether the CHEER results are data frequency-dependent.Design/methodology/approachThe present study uses monthly data ranging from 1997M01 to 2016M12 and considers the US economy as the representative foreign country. The study uses structural break unit root test and structural break cointegration technique to test the presence of economic relationships between nominal exchange rates and each of the price and interest rate differentials. Then, the study examines the validity of the CHEER approach by testing the appropriate theoretical restrictions.FindingsThe cointegration results suggest the existence of two cointegrating vectors representing UIP and PPP conditions. For all countries, the data appear to support the hypothesis that the system contains UIP and PPP relations. However, each of the international parity hypotheses is strongly rejected when formulated in isolation and jointly, leading to repudiation of the CHEER validity. Further, it is found that the results are data frequency-dependent and suggest that higher frequencies should be used as they provide additional information.Originality/valueFirst, the literature on equilibrium exchange rates in BRICS economies is scanty. BRICS economies are large-emerging economies and one of the fastest growing economies and thus entail an empirical enquiry on their exchange rates. Second, the empirical application has mainly used monthly data to test the validity of the CHEER approach. However, data frequencies could affect the results. To the best of the authors’ knowledge, this study is the first to check data frequency-dependency in examination of the CHEER approach.

Asset prices with stochastic volatilities and a UIP puzzle

In this paper, I extend the two-country general equilibrium model with smooth transition regimes in volatilities to examine the time-varying features of foreign exchange excess returns. The representative agent is assumed to have the Epstein-Zin-Weil preference, which allows the long run risks and macroeconomic uncertainties to be priced. The smooth transition in volatilities generates another route of uncertainty in macroeconomic variabilities for each country, which plays an important role in determining the behavior of changes in exchange rates and interest differentials across countries. Furthermore, I present an explanation for the failure of the uncovered interest parity condition, showing that the expected excess returns can be negatively correlated with the interest differential in the model. The results of the simulation show that if the representative agent with the Epstein-Zin-Weil utility prefers early resolution of uncertainty, the uncovered interest parity puzzle can be explained.

Testing the interest-parity condition with Irving Fisher's example of Indian rupee and sterling bonds in the London financial market, 1869–1906

Following the pioneering work of Irving Fisher, this article assesses the uncovered interest-parity (UIP) condition by comparing Indian interest and exchange rates during the 1869 to 1906 period. The Indian case provides a good example of the UIP condition, since Indian rupee and sterling bonds were simultaneously traded in the London financial market and subject to negligible default risks. Large deviations from the UIP condition arose when India suffered from pervasive levels of uncertainty about the future of its silver-based currency system. Otherwise, a relatively close correlation arises between sterling-to-rupee interest-rate differences and exchange-rate changes.

Inflation targeting and the forward bias puzzle in emerging countries

Based on quarterly data on 31 emerging countries (among which 16 are inflation targeting countries) from 1990Q1 to 2014Q3, we obtain a strong support for the conjecture that the implementation of inflation targeting weakens the Fisherian relation between expected depreciation and the interest rate differential (uncovered interest parity condition) and thus is conducive to the appearance of the forward bias puzzle in emerging countries. We show that this reflects the performance of inflation targeting regimes in lowering the level and volatility of inflation. Our finding holds when controlling for country-specific effects, time-specific effects, global disinflation, exchange rate management, crises, and using different econometric techniques.

Uncovered Interest Rate Parity: The Turkish Evidence

AbstractThis paper presents an empirical investigation of the uncovered interest parity (UIP) between the Turkish Lira (TRY)/US Dollar (USD) and Turkish Lira/Euro (EUR). Our results do not provide evidence supporting the UIP hypothesis for either case. Moreover, the estimates imply causality from the TRY/USD exchange rate return to the interest rate differential. Accordingly, the Turkish Central Bank (CBRT) may respond by increasing the domestic interest rate to a depreciation of the TRY against the USD . By taking this type of action, it can be concluded that the CBRT tried to control capital movements. This result supports (McCallum, Bennett T. 1994. “A Reconsideration of the Uncovered Interest Parity Relationship.”Journal of Monetary Economics33 (1): 105–132.)’s argument, which advances the behavior of the monetary policy as a reason for the failure of the UIP condition.

Importance Of Real And Nominal Shocks In Us Macroeconomic And Exchange Rate Fluctuations

It is important for the policy makers to know what kinds of shocks are responsible for macroeconomic fluctuations or recession to formulate appropriate policy responses. This paper exploits a stylized model to identify the sources of macroeconomic and exchange rate fluctuations in the US. The model consists of a productivity equation, a demand function, an exchange rate augmented Phillips curve, a monetary policy rule and an exchange rate equation (uncovered interest parity (UIP) condition). The stylized model implies a set of short-run restrictions that allow for the identification of the structural shocks in a vector autoregression model in order to test the model’s consistency with data. We use real GDP for output, GDP deflator for price, Federal fund rate (FF) as monetary policy. The other two variables are unemployment rate and Nominal effective exchange rate (NEER). Throughout the analyses oil price is used as an exogenous variable. The Sample period starts from 1980q1, and ends at 2008 q2 to avoid possible non-linearity arise from 2008 financial crisis. Results show that more than half of the fluctuation in unemployment and output is explained by two shocks namely productivity/technology shock and aggregate demand shock. Monetary policy shock can explain around 15 per cent while supply and exchange rate shock explain less than 10 percent of the variation in unemployment and output. These results from our simple model are compatible with those from more sophisticated models found in current literature. Hence, our model is more appealing to the policy makers. Further, to gauge the importance of monetary policy in stabilizing the economy, a counterfactual simulation exercise is performed. The exercise shows that monetary policy has stabilized inflation and unemployment, though at the cost of increasing variability in output. The findings of this paper emphasize that policy makers should be aware of the importance of demand side shocks such as policy uncertainty and money supply. A positive uncertainty shock (an increase in uncertainty) may reduce investment and may slow the economic recovery. On the other hand, a prolong period of expansionary monetary policy may make the inflation expectations less anchored. Therefore, the policy makers should try to keep the impact of policy uncertainty at the minimum level and should follow prudent monetary policy.

The macroeconomic impact of foreign exchange intervention: An empirical study of Thailand

This paper focuses on empirically investigating the efficacy of foreign exchange intervention in the Thai economy by simulation analyses. We find that foreign reserves are determinants of exchange rate dynamics, whereas the uncovered interest parity condition does not hold. We also find that foreign exchange intervention influences the inflation rate via the exchange rate, although by a lesser degree, whereas such an intervention for an extended period is likely to incur higher costs of the macro economy.

When the Bubble Bursts: Monetary Policy Rules and Foreign Exchange Market Behavior

We examine the effects of a “bubble” in the foreign exchange market, defined as an exogenous process that temporarily shifts the exchange rate away from the value implied by fundamentals. The bubble process is analogous to Bernanke and Gertler’s (1999) specification of an asset price bubble. We evaluate the performance of alternative simple monetary policy rules under both bubble and no-bubble scenarios and investigate whether policymakers should react to the deviation of the exchange rate from its steady-state value. The policy experiments employ a small-scale forward-looking structural model calibrated to UK data, which we previously used in Batini and Nelson (2000). For this model, which includes an uncovered interest parity condition, we find that the appropriate response to the exchange rate is captured by the expected inflation term, provided that the response coefficient and the inflation horizon are optimized. When uncovered interest parity is relaxed, there appears to be more merit in incorporating a separate exchange rate term in the monetary policy rule.

Monetary Policy Regime Shifts and Uncovered Interest Parity Revisited: The Euro–US Dollar Exchange Rate

ABSTRACTTo explore possible sources of the well-documented uncovered interest parity (UIP) violation in the foreign exchange market, this paper scrutinizes structural changes in monetary reactions to inflationary pressure in the conventional approaches to nominal exchange rate and examines how this small but important change has an effect on the empirical implications of the UIP condition. In addition to some salient features found in the euro exchange rate, by introducing occasional monetary policy regime shifts into an otherwise standard open-economy dynamic general equilibrium model, we found some important findings that potentially help better understand exchange rate dynamics. During the entire sample period, 1999:M1–2014:M8, exchange rate disconnect puzzle still exists. However, sub-sample analysis suggests that relatively passive monetary reaction implying less frequent intervention by monetary authority tends to be more consistent with the UIP relation. Simulation results support the empirical regularities.

Panel Data Models and the Uncovered Interest Parity Condition: The Role of Two-Way Unobserved Components

This paper endeavours to show how the specification of the regression testing the uncovered interest parity (UIP) condition can determine whether or not the hypothesized proportional relationship between international interest rate differences and exchange rate changes is rejected. Across major currencies, various terms to maturity, different data frequencies and the short as well as the long time horizon, single-equation regressions partly reject the UIP condition. However, this ‘UIP puzzle’ tends to disappear when panel data regressions account, for example, for risk premiums by means of two-way unobserved component specifications with random or fixed effects for both currencies and time periods. The closest concurrence with the UIP condition arises when specifying the time-specific component as fixed effect, which provides a way to address the potential bias when unobserved exchange rate risk premiums correlate with interest rates. Copyright © 2016 John Wiley & Sons, Ltd.