Uncovered Interest Rate Parity Condition Research Articles

Breaking the UIP: A Model-Equivalence Result

Breaking the uncovered interest rate parity (UIP) condition is essential to accounting for the empirical behavior of exchange rates, and is a prerequisite for theoretical analysis of sterilized foreign exchange interventions. Gabaix and Maggiori (2015) account for some of the long-standing empirical exchange rate puzzles by introducing financial intermediaries that are willing to absorb international saving imbalances for a premium, thereby deviating from the UIP. In another important contribution, Fanelli and Straub (2019) lay down the principles for foreign exchange interventions. In their model, regulatory exposure limits and participation cost in the international financial markets drive a wedge in the UIP. This paper demonstrates that, to a first order approximation, these models are equivalent to a reduced-form portfolio adjustment cost model, as in Schmitt-Grohe and Uribe (2003). Therefore, to the extent that one is only concerned with first-order dynamics and second moments, there is no gain from adopting the rich microstructure of either models -- a simple portfolio adjustment cost is just as good.

The Impact of Oil Shocks in a Small Open Economy New-Keynesian Dynamic Stochastic General Equilibrium Model for an Oil-Importing Country: The Case of South Africa

ABSTRACT This article studies the effects of foreign (real) oil price shocks on key macroeconomic variables for South Africa: a net-importer of oil. We develop and estimate a small open economy New-Keynesian dynamic stochastic general equilibrium model with a role for oil in consumption and production. The substitutability of oil for capital and consumption goods is low, import price pass-through is incomplete, domestic and foreign prices and wages are sticky, and the uncovered interest rate parity condition holds imperfectly. Foreign real oil price shocks have a strong and persistent effect on domestic production and consumption activities and, hence, are a fundamental driver of output, inflation, and interest rates in both the short- and long-run. Oil price shocks also generate a trade-off between output and inflation stabilization. As a result, episodes of endogenous tightening of monetary policy slow the recovery of South Africa’s real economy. Our findings go further to suggest an important role for oil prices in predicting South African output during and after the recession that followed the 2008 global financial crisis.

Government bond yields in Germany and Spain—empirical evidence from better days

This paper tries to link the uncovered interest rate parity condition to the discussion about interest rate convergence in currency unions. Techniques of fractional cointegration analysis are used to examine the relationship between German and Spanish government bond yields with maturities of two, five, seven and ten years in the period 05 January 2001 to 29 December 2006. Back then (in the good times of the currency union) financial markets did not have to fear exchange rate risk and sovereign credit risk. Thus, the risk premia to be observed were small and driven by liquidity risk. Economic theory suggests that a cointegration vector of between the interest rates can only exist when markets do not expect exchange rate movements and the risk premium is not interest rate sensitive (or practically speaking the sensitivity is low). Given the data set examined here, it is probably no surprise that the interest rates of the two countries are cointegrated and that the cointegration vector of German and Spanish government bond yields with maturities of two, five and seven years seems to be . We then have also examined the degree of interest rate sensitivity of the yield spread between Spain and Germany. The differential between the yields of the two countries in all maturity brackets do not react to the level of interest rates in the currency union. This fits perfectly to our results with regard to the cointegration vector.

An Empirical Examination of Risk Premiums in the Indian Currency Futures Market

Abstract In this paper, we examine whether risk premiums are significant in explaining the deviations from the uncovered interest rate parity (UIP) condition in an emerging Indian currency futures market. In particular, we explore the unbiasedness of futures quotes as a predictor of the future spot exchange rate to understand the forward premium anomaly condition. We report huge deviations from the UIP condition for all currencies considered and show that these deviations are explained by the risk premium. The realized risk premiums for all currencies are found to be negative and significantly different from zero, which suggests that investors are awarded for taking short positions in the foreign currency. The realized risk premiums in turn are found to be negatively related to the current spot rate returns and positively to the futures premium, conditional variance of spot rate returns, and the dividend yield.

Uncovering the portfolio balance channel with the use of sovereign credit ratings

In this paper we study exchange rate effects due to shifts in the portfolio composition of the Colombian financial sector during 2003–2014. We first provide a theoretical understanding of the channel's transmission mechanism by modeling how the banking sector optimally allocates its portfolio composition. This allows us to characterize departures from the uncovered interest rate parity condition (UIP) in terms of foreign and domestic assets. In the empirical application, we control for a potential simultaneity bias by using a novel instrument for portfolio compositions: the use of sovereign credit ratings and outlook changes made by Moody's, Standard and Poor's and Fitch Ratings. Our findings indicate that shifts in portfolio balances affect only the long term (5-year) risk premium in up to five months before the effects subside. Additionally, we find stronger and more persistent portfolio effects in cases in which US ratings increased relative to Colombian ratings.

Explaining Exchange Rate Anomalies in a Model with Taylor-Rule Fundamentals and Consistent Expectations

We introduce a form of boundedly-rational expectations into a standard asset-pricing model of the exchange rate, where cross-country interest rate differentials are governed by Taylor-type rules. We postulate that agents augment a lagged-information random walk forecast with a term that relates to news about Taylor-rule fundamentals. We solve for a ?consistent expectations equilibrium,? in which the coefficient on fundamental news in the agent?s forecast rule is pinned down using the moments of observable data. The forecast errors observed by the agent are close to white noise, making it di cult for the agent to detect any misspecification. We show that the model generates volatility and persistence that is remarkably similar to that observed in monthly bilateral exchange rate data (relative to the U.S.) for Canada, Japan, and the U.K. over the period 1974 to 2012. Moreover, we show that regressions performed on model-generated data can deliver the well-documented forward premium anomaly whereby a high interest rate currency tends to appreciate, thus violating the uncovered interest rate parity condition.

Upside and Downside Risk Exposures of Currency Carry Trades via Tail Dependence

Currency carry trade is the investment strategy that involves selling low interest rate currencies in order to purchase higher interest rate currencies, thus profiting from the interest rate differentials. This is a well known financial puzzle to explain, since assuming foreign exchange risk is uninhibited and the markets have rational risk-neutral investors, then one would not expect profits from such strategies. That is, according to uncovered interest rate parity (UIP), changes in the related exchange rates should offset the potential to profit from such interest rate differentials. However, it has been shown empirically, that investors can earn profits on average by borrowing in a country with a lower interest rate, exchanging for foreign currency, and investing in a foreign country with a higher interest rate, whilst allowing for any losses from exchanging back to their domestic currency at maturity. This paper explores the financial risk that trading strategies seeking to exploit a violation of the UIP condition are exposed to with respect to multivariate tail dependence present in both the funding and investment currency baskets. It will outline in what contexts these portfolio risk exposures will benefit accumulated portfolio returns and under what conditions such tail exposures will reduce portfolio returns.

Price and liquidity puzzles of a monetary shock: Evidence from indebted African economies

Price and liquidity puzzles have been identified as two major counterintuitive findings arising from monetary shocks. We investigate their presence in eleven African countries, using a dynamic stochastic general equilibrium model designed for indebted small open-economies. Our simulations reveal that the majority of African countries report a price puzzle whereas only three countries exhibit liquidity effect. In many of the sampled countries, a positive money growth shock drives interest rates up, but consumption and output fall in contrast to the conventional view. External debt increases in response to money growth shock, exchange rate appreciates and inflation falls. Money growth shocks are transmitted to the economy through the exchange rate channel when uncovered interest rate parity condition holds. Our findings therefore appear to suggest that monetary policy in Africa should prioritize foreign debt stabilization by reacting more to output gap than to inflation.

Uncovered interest rate parity on the Japanese yen exchange rate market

The aim of the paper is to verify the uncovered interest rate parity hypothesis on the Japanese yen exchange rate market. The article describes the theory of uncovered interest rate parity and presents the review of previous research results. Moreover, the paper characterizes the currency speculation strategy „carry trade” which is fundamentally based on the assumption that the uncovered interest rate parity doesn’t hold. The Japanese yen is one of the most popular „carry trade” funding currency and therefore the article is focused on the analysis of this exchange rate market.The uncovered interest rate parity condition suggests that „carry trade” strategy should not result in excess profits. However, the high average payoff to „carry trade” is widely documented by many researchers and thus it may imply that uncovered interest rate parity doesn’t hold on the Japanese yen market. The uncovered interest rate parity on the Japanese yen market is tested by applying the conventional regression approach and orthogonality test of the forward rate forecast error. The results show that it is hard to say definitely that uncovered interest rate parity holds on the analyzed exchange rate market. The uncovered interest rate parity hypothesis is rejected for JPY/TRY market. However, there is not enough evidence to reject UIP hypothesis for JPY/NZD and JPY/USD exchange rate markets.

COMMON FACTORS OF THE EXCHANGE RISK PREMIUM IN EMERGING EUROPEAN MARKETS

ABSTRACTExisting empirical evidence suggests that the Uncovered Interest Rate Parity condition may not hold due to an exchange risk premium. For a panel dataset of eleven emerging European economies we decompose this exchange risk premium into an idiosyncratic (country‐specific) element and a common factor using a principal components approach. We present evidence of stationary idiosyncratic and common factors. This result leads to the conclusion of a stationary risk premium for these countries, which is consistent with previous studies often documenting a stationary premium in advanced countries. Furthermore, we report that the variation in the premium is largely attributable to a common factor influenced by economic developments in the United States.

Carry-trades on the yen and the Swiss franc: are they different?

Using monthly data from 1986 to 2009 for 11 major currencies against the U.S. dollar (USD), we find that interest rate differentials between nine of these currencies are generally positive (sample mean of 0.86%) but are strongly negative for Japan (mean of −2.78%) and for Switzerland (mean of −2.22%). Investigating empirical models of nominal exchange rate changes we find for all panels that about 2% of real exchange rate misalignments are corrected in the following month. We also find important differences across samples and for the two carry-trade currencies the key results are as follows. First, interest rate differentials have a negative impact on exchange rates: higher paying currencies should appreciate, contrary to the ex-ante uncovered interest rate parity (UIP) condition. We find that this result is very robust to money supply (M1) differentials serving as instrumental variables to inflation rates. In addition, these two currencies depreciate slightly when money supply (M1) differentials increase. Second, dummy variables for periods of market turmoil suggest a particularly strong appreciation of these currencies against the USD, consistent with the unwinding of carry-trade activities.

A STRATEGIC MARKET GAME OF CARRY TRADES AND EQUILIBRIUM PROFITS*

We formalize carry trade in a two-country, two-period general equilibrium strategic market game model of an economy with no uncertainty where agents are not price takers. We show that when carry trade occurs at a Nash equilibrium it is profitable and is identified with the failure of the uncovered interest rate parity condition. Carry trade profits are attributed to asymmetric elasticities in currency or credit markets across time. Furthermore, at equilibrium, real national interest rates may not equalize across countries thus violating the standard international Fisher effect.

Exchange Rates under Robustness: An Account of the Forward Premium Puzzle

We show that robustness against model misspecification can account for the forward premium puzzle through a combination of an exchange rate model and a robustness model under structured uncertainty. In equilibrium, optimizing agents, who hold no misperception about the model, distort their forecasts to attain robustness against potential misspecification. This forecast distortion generates a delayed overreaction of exchange rates to interest rate differential shocks that leads to a negative unconditional correlation between exchange rate changes and interest rate differentials, i.e., a negative Fama coefficient. Using change-of-measure techniques, we derive the familiar uncovered interest rate parity condition—under distorted expectations—and the Fama coefficient in closed-form. We calibrate our model with empirical estimates of key parameters and are able to generate a negative Fama coefficient under sufficient uncertainty-aversion.

Idiosyncratic Consumption Risk and Predictability of the Carry Trade Premium: Euro Area Evidence

The empirical failure of the uncovered interest rate parity condition seems to be the reflection of risk premia on foreign currencies. After the formation of foreign currency portfolios according to interest rate differentials or forward discounts, recent studies suggest that either consumption- or currency return-based pricing factors explain the cross-section of foreign currency portfolio returns. The contribution of this paper is twofold. It shows that the returnbased explanation applies to foreign currency portfolios sorted from the perspective of a Euro Area investor. Secondly, the main results of this paper suggest that the decisive pricing factor, the so called carry trade premium, mirrors business cycle related risks. Times of relatively large amounts of uninsured Euro Area consumption growth risk are associated with an expected increase of the carry trade premium.

Real Exchange Rate Volatility and Disconnect: An Empirical Investigation

A two-country model that incorporates many features proposed in the New Open Economy Macroeconomics literature is developed in order to replicate the volatility of the real exchange rate and its disconnect with macroeconomic variables. The model is estimated using data for the euro area and the U.S. and Bayesian methods. The analysis delivers the following results: (a) international price discrimination, home bias and shocks to the uncovered interest rate parity (UIRP) condition are key features to replicate the variance of the real exchange rate; (b) home bias, shocks to the UIRP condition and to production technologies help replicating the disconnect; (c) distribution services intensive in local nontradeables are an important source of international price discrimination.

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Expectations hypotheses tests at Long Horizons

Summary Many rational expectations models state that an economic variable is determined as the present value of future variables. These restrictions have traditionally been tested on VARs where variables appear either in levels (or cointegrating relationships) or first differences. When variables are highly persistent, commonly used test statistics may lead to overrejections in small samples. We propose an alternative method based on local-to-unity asymptotic approximations that has good coverage properties, and can be applied to jointly test across horizons. We apply this method to the Term Structure of Interest Rates, the Uncovered Interest Rate Parity condition, and the Permanent Income Hypothesis. The method can also be used to perform inference in long-horizon predictive regressions.

Evaluating an Estimated New Keynesian Small Open Economy Model

This paper estimates and tests a new Keynesian small open economy model in the tradition of Christiano, Eichenbaum, and Evans (2005) and Smets and Wouters (2003) using Bayesian estimation techniques on Swedish data. To account for the switch to an inflation targeting regime in 1993 we allow for a discrete break in the central bank's instrument rule. A key equation in the model - the uncovered interest rate parity (UIP) condition - is well known to be rejected empirically. Therefore we explore the consequences of modifying the UIP condition to allow for a negative correlation between the risk premium and the expected change in the nominal exchange rate. The results show that the modification increases the persistence and volatility in the real exchange rate and that this model has an empirical advantage compared with the standard UIP specification.

Evaluating an estimated new Keynesian small open economy model

This paper estimates and tests a new Keynesian small open economy model in the tradition of Christiano et al. [2005. Nominal rigidities and the dynamic effects of a shock to monetary policy. Journal of Political Economy 113(1), 1–45] and Smets and Wouters [2003. An estimated stochastic dynamic general equilibrium model of the Euro area. Journal of the European Economic Association 1(5), 1123–1175] using Bayesian estimation techniques on Swedish data. To account for the switch to an inflation targeting regime in 1993 we allow for a discrete break in the central bank's instrument rule. A key equation in the model – the uncovered interest rate parity (UIP) condition – is well known to be rejected empirically. Therefore we explore the consequences of modifying the UIP condition to allow for a negative correlation between the risk premium and the expected change in the nominal exchange rate. The results show that the modification increases the persistence in the real exchange rate and that this model has an empirical advantage compared with the standard UIP specification.