Uncovered interest parity puzzle: does it really exist?

Abstract

Most studies indicate the violation of the Uncovered Interest Parity (UIP) restrictions, and indeed, there are many who find a statistically significant and negative interest rate differential slope. This finding has now become known in international economics as the UIP puzzle. Using recent data on four major currencies vis-à-vis the US dollar and employing the Generalized Method of Moments (GMM) technique, our estimation results indicate the absence of any relationship between the interest rate differential and the expected change in the exchange rate, rather than the presence of the UIP puzzle.

Notes

¹ For further references on this issue see Lothian and Wu (2005), Isard (2006) and Aslan and Korap (2008).

² GMM estimation has been applied in a recent paper that examines the UIP hypothesis (Aslan and Korap, 2008). Their empirical results verify the failure of the parity over the period 1987–2006.

³ All quoted interest rates are in percentages. The exchange rates used in the estimation are expressed in natural logarithms. Stock returns (in percentages) are measured by

where P is the stock price index.

⁴ Due to data limitations on Japanese long-term interest rates, the sample period for the Japan/USA pair starts in January 1989.

⁵ Results for the J-statistic are available upon request.