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Co‐integrating currencies and yield differentials

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  • Ahmet Can Inci

Abstract

This study investigates the relationship between currencies and interest rates of different maturity horizons. The real exchange rate is found to depend both on short‐term real domestic and foreign interest rate difference and on long‐term real domestic and foreign interest rate difference. Co‐integrating regressions of contemporaneous currency rates generate negative and significant coefficients for long‐term rate differentials, consistent with uncovered interest parity. Therefore, the expectations hypothesis holds for long horizons. On the other hand, positive coefficients for real short‐term interest rate differentials reveal the forward premium puzzle: the failure of uncovered interest parity for short‐horizons. Results are partly driven by the very different risk characteristics of short‐term bonds and foreign bonds.

Suggested Citation

  • Ahmet Can Inci, 2006. "Co‐integrating currencies and yield differentials," Review of Financial Economics, John Wiley & Sons, vol. 15(2), pages 159-175.
    • Handle: RePEc:wly:revfec:v:15:y:2006:i:2:p:159-175
    DOI: 10.1016/j.rfe.2005.04.004
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