A Revisit on the Validity of the Uncovered Interest Rate Parity-Evidence from Time-Varying Parameter Models

ABSTRACT

This paper develops two time-varying parameter uncovered interest parity (TVP-UIP) models and studies their validity in both developed and emerging countries. Compared to the traditional models, TVP-UIP models can successfully capture dynamic relationships and help to explain the UIP puzzle. Empirical results show that the coefficients vary substantially over time and the UIP relationship can be regarded as a dynamic equilibrium process especially in emerging economies. The UIP hypothesis holds in several periods and can be significantly affected by specific major events, such as the financial crises and the recovery policies in response to it, or the US monetary policy changes. The time-varying risk premium attracts great concern in the literature but only plays a limited role in this case. Moreover, the failure of UIP in some periods can be attributable to the persistence inherent in the data, which leads to a long-lasting re-establishment of the UIP relationship after a shock.

KEYWORDS:

• Uncovered interest parity
• time-varying coefficient
• sieve MLE
• risk premium

JEL CLASSIFICATION:

• C51
• F36
• G15

Disclosure of potential conflicts of interest

No potential conflict of interest was reported by the author(s).

Notes

¹ The five developed countries are Australia, Canada, Japan, Switzerland and the UK, all of which have open financial markets and few limitations on capital flows. The five emerging countries are Brazil, China, Malaysia, Mexico and Thailand, all of which have marketized the interest rates except for China. Though China has more capital controls, it has also implemented a managed floating exchange rate regime since 2005.

Additional information

Funding

This project was supported by the National Natural Science Foundation of China (NSFC) (No. 71803041), Humanity and Social Science Youth Foundation of the Ministry of Education of China(No.17YJC790106), and the China Postdoctoral Science Foundation(No.2018T110820)