Uncovered Interest Parity Condition Research Articles

Foreign Exchange Risk Premium Determinants: Case of Armenia

This paper studies foreign exchange risk premium using the uncovered interest rate parity framework in a single country context. The analysis is performed using weekly data on foreign and domestic currency deposits in Armenian banking system. The paper provides the results of the simple tests of uncovered interest parity condition, which indicate that contrary to established view dominating in empirical literature there is a positive correspondence between exchange rate depreciation and interest rate differentials in Armenian deposit market. Furthermore, the paper presents and discusses a systematic positive risk premium required by the economic agents for foreign exchange transactions, which increases over the investment horizon. The two currency affine term structure framework is applied to identify the factors driving the systematic exchange rate risk premium in Armenia. At the end, possible directions for further research are outlined.

Practical Model-Based Monetary Policy Analysis: A How-To Guide

This paper provides a how-to guide to model-based forecasting and monetary policy analysis. It describes a simple structural model, along the lines of those in use in a number of central banks. This workhorse model consists of an aggregate demand (or IS) curve, a price-setting (or Phillips) curve, a version of the uncovered interest parity condition, and a monetary policy reaction function. The paper discusses how to parameterize the model and use it for forecasting and policy analysis, illustrating with an application to Canada. It also introduces a set of useful software tools for conducting a model-consistent forecast.

Practical Model-Based Monetary Policy Analysis: A How-To Guide

This paper provides a how-to guide to model-based forecasting and monetary policy analysis. It describes a simple structural model, along the lines of those in use in a number of central banks. This workhorse model consists of an aggregate demand (or IS) curve, a price-setting (or Phillips) curve, a version of the uncovered interest parity condition, and a monetary policy reaction function. The paper discusses how to parameterize the model and use it for forecasting and policy analysis, illustrating with an application to Canada. It also introduces a set of useful software tools for conducting a model-consistent forecast.

International tax arbitrage, financial parity conditions and preferential capital gains taxation

Using a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation when interest income and capital gains/losses are taxed differentially for some agents. We derive tax-modified uncovered interest parity conditions, Fisher conditions and forward prices similar to the no-tax ones, but augmented by tax-induced ‘risk-premium’ terms; covered interest parity and Fisher conditions remain unaffected by the introduction of capital income taxes as we bound tax-based arbitrage without restricting arbitrage per se.

Managed Floating as a Monetary Policy Strategy

Although there seems to be a broad consensus among economists that purely floating or completely fixed exchange rates (the so-called corner solutions) are the only viable alternatives of exchange rate management, many countries do not behave according to this paradigm and adopt a strategy within the broad spectrum of exchange rate regimes that is limited by the two corner solutions. Many of these intermediate regimes are characterized by significant foreign exchange market interventions and a certain degree of exchange rate flexibility with non-preannounced exchange rate targets. While academic research in this area usually concentrates on some specific aspects of intermediate regimes (such as the effectiveness of interventions or institutional aspects), managed floating has rarely been analyzed as a comprehensive monetary policy strategy. In this paper, we present a monetary policy framework in which central banks simultaneously use the exchange rate and the interest rate as operating targets of monetary policy. We explain the mechanics of foreign exchange market interventions and sterilization and we explain why a central bank has an interest of controlling simultaneously the two operating targets. We derive the monetary policy rules for the two operating targets from a simple open economy macro model in which the uncovered interest parity condition and the monetary conditions index play a central role.

Following in Their Footsteps: Comparing Interest Parity Conditions in Central European Economies to the Euro Countries

This paper investigates capital market integration in the major Central European emerging economies by testing the covered and uncovered interest parity conditions vis-a-vis the U.S. dollar and the DM/euro. The results for the Central European economies since 1997 are contrasted against those of the euro countries during the period preceding the introduction of the euro. This allows a comparison of conditions in the capital markets in the Central European economies versus those in the pre-euro EU. The results suggest that capital mobility and exchange rate market efficiency in Central Europe are remarkably similar to conditions in the EU during the 1990s.

A Fiscal Theory of the Currency Risk Premium and of Sterilized Intervention

This paper develops a dynamic stochastic general equilibrium monetary portfolio choice model that accomplishes two objectives. First, it provides a theory of currency risk premia based on a weak and plausible form of fiscal nonneutrality. Domestic and foreign bonds become imperfect substitutes, the uncovered interest parity condition is replaced with a portfolio balance equation, and the central bank can separately choose the growth rate of its nominal anchor and the domestic bond interest rate. Second, it can turn be shown that, and how, sterilized intervention affects equilibrium allocations and prices.

A Fiscal Theory of the Currency Risk Premium and of Sterilized Intervention

This paper develops a dynamic stochastic general equilibrium monetary portfolio choice model that accomplishes two objectives. First, it provides a theory of currency risk premia based on a weak and plausible form of fiscal nonneutrality. Domestic and foreign bonds become imperfect substitutes, the uncovered interest parity condition is replaced with a portfolio balance equation, and the central bank can separately choose the growth rate of its nominal anchor and the domestic bond interest rate. Second, it can turn be shown that, and how, sterilized intervention affects equilibrium allocations and prices.

International tax arbitrage, tax evasion and interest parity conditions

Using a finite-horizon general equilibrium model with uncertainty and money, we characterize situations where tax arbitrage opportunities may arise for international portfolio investors in an economy with heterogeneous capital income taxation when there is some scope to evade taxes on foreign capital income. We derive tax-modified uncovered interest parity conditions and forward rates similar to the no-tax ones, but augmented by tax-induced “risk-premium” terms; covered interest parity conditions remain unaffected by the introduction of capital income taxes, a consequence of our approach of bounding tax-based arbitrage without restricting arbitrage per se.

Managed Floating: Understanding the New International Monetary Order

Although there seems to be a broad consensus among economists that purely floating or completely fixed exchange rates (the so-called corner solutions) are the only viable alternatives of exchange rate management, many countries do not behave according to this paradigm and adopt a strategy within the broad spectrum of exchange rate regimes that is limited by the two corner solutions. These intermediate regimes are characterized by significant foreign exchange market interventions of central banks and a certain degree of exchange rate flexibility. We develop a new empirical methodology that identifies three different forms of floating on the basis of a central bank’s intervention activity: pure floating (no interventions), independent floating (exchange rate smoothing), and managed floating (exchange rate targeting). Our cross-country study shows that exchange rate targeting is at least as important as exchange rate smoothing. Subsequently we present a monetary policy framework in which central banks use the exchange rate as an operating target of monetary policy. We explain the mechanics of interventions and sterilization and we explain why a central bank has an interest of controlling simultaneously the exchange rate and the short-term interest rate. We derive the monetary policy rules for our two operating targets from a simple open economy macro model in which the uncovered interest parity condition and the Monetary Conditions Index play a central role.

TIME‐VARYING ESTIMATES ON THE OPENNESS OF CAPITAL ACCOUNTS IN EAST ASIA AND MEXICO

HE Asian currency crisis of 1997 and its reverberations in financial markets of developing countries around the world have intensified the debate over regulating the movement of capital, as capital flows to developing countries have grown rapidly since the early 1990s. One main feature of recent capital flows to developing countries is that private (bond and equity) flows, as opposed to official flows, have become a crucial source for financing large current account imbalances. The evolution and magnitude of capital movements have presented both opportunities and challenges to the developing countries. The degree of capital mobility has typically been assessed by the extent to which expected returns are equalized between domestic and foreign assets of the same type. The equalization of returns can be measured by simple interest arbitrage which typically focuses on the short-run relationship between capital flows and interest differentials. Capital mobility is defined as the absence of barriers to the movement of short-term capital across national boundaries. We can examine covered interest differentials for only a subset of countries with relatively well-developed forward markets, and many papers have looked at the mobility of financial capital for industrial countries. 1 Unfortunately, for a majority of countries that are liberalizing or contemplating liberalization, forward markets are either extremely thin or nonexistent, rendering covered interest parity tests irrelevant and making it difficult to judge the economic impact of capital account liberalization. Therefore, tests of uncovered interest parity conditions have been applied to examine the degree of capital mobility in most developing countries, although there is little evidence to show that uncovered interest parity conditions hold. This paper examines interest rate determination in two polar cases related to the degree of openness of the economy. If the economy under consideration is one that

Exchange rate anomalies in the industrial countries: A solution with a structural VAR approach

Past empirical research on the effects of monetary policy in closed and open economies found evidence of several anomalies, such as the ‘liquidity’, ‘price’, ‘exchange rate’ and ‘forward discount bias’ puzzles. In this paper, we develop an approach that provides a solution to these empirical anomalies in an open economy setup. We use a ‘structural VAR’ approach with non-recursive contemporaneous restrictions and we identify monetary policy shocks by modeling the reaction function of the monetary authorities and the structure of the economy. Our empirical findings are that effects of non-US G-7 monetary policy shocks on exchange rates and other macroeconomic variables are consistent with the predictions of a broad set of theoretical models. The evidence is consistent with significant, but transitory, real effects of monetary shocks. The ‘price’ puzzle is addressed and there is little evidence of open economy anomalies. Specifically, initially the exchange rate appreciates in response to a monetary contraction; but after a few months, the exchange rate depreciates over time in accordance with the uncovered interest parity condition. Overall, our identification scheme gives results that contribute to resolve the empirical anomalies about the effects of monetary policy shocks found in the literature.

Monetary Policy and Exchange Rate Targeting in Open Economies

We develop an institutional framework for central banks that try to pursue a stability-oriented monetary policy in open-economies by directly targeting the exchange rate. Our main intention is to design a framework which avoids excessive capital inflows that can be regarded as a main cause of the crises in Asia, Latin America, Eastern and Central Europe and of the ERM I. In an open economy policy makers can target two interrelated variables: the interest rate and the exchange rate. These two operating target have to fulfil two different conditions. On the one hand they have to create monetary conditions that are consistent with the domestic economic situation. On the other hand they have to be compatible with a risk-premium adjusted uncovered interest parity condition (UIP). It is obvious that both conditions are difficult to met. In our view sustained violations of the second condition provide an important explanation for the problem of speculative capital inflows under a fixed nominal peg. We show that an adjustable nominal peg is in most cases a better solution to the dual requirement of UIP and adequate monetary conditions. This leads to a new solution for the inconsistency triangle: a central bank can combine an autonomous domestic interest rate policy with capital mobility and a floor for the target path of the exchange rate.

Uncovered interest parity: New Zealand' s post-deregulation experience

The uncovered interest parity (UIP) condition has been the subject of a considerable amount of research. Many of these studies, however, have either measured exchange rate expectations indirectly and/or have not considered the issue of data stationarity. Both of these issues have the potential to render tests of UIP problematical. This paper tests for the presence of UIP between New Zealand and four of its key trading partners using an approach that addresses both of the above issues. Strong evidence is found that UIP held between New Zealand and Australia in the period following the removal of capital controls, indicating that the capital markets of these two countries are now highly integrated.

Optimal monetary policy with an interest-equalization tax in a two-country macroeconomic model

This paper examines the coordination of monetary policy and an interest-equalization tax stabilizer within a two-country macroeconomic model. Within this two-country framework, which allows for wage indexation and includes an imported intermediate good, monetary policy is shown to be severely constrained by the uncovered interest parity condition implied by perfect capital mobility. Introduction of an interest-equalization tax stabilizer into the model significantly enhances policy makers' ability to stabilize output (or price) in the two countries.

The Interest Rate Parity Theorem: A Reinterpretation

The Interest Rate Parity Theorem: A Reinterpretation