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Uncovering Yield Parity: A new insight into the UIP puzzle through the stationarity of long maturity forward rates

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Author Info
Zsolt Darvas
Gábor Rappai
Zoltán Schepp

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Abstract

Results and models of this paper are based on a strikingly new empirical observation: long maturity forward rates between bilateral currency pairs of the US, Germany, UK, and Switzerland are stationary. Based on this result, we suggest a new explanation for the UIP-puzzle maintaining rational expectations and risk neutrality. The model builds on the interaction of foreign exchange and fixed income markets. Ex ante short run and long run UIP and the EHTS is assumed. We show that ex post shocks to the term structure could explain the behavior of the nominal exchange rate including its volatility and the failure of ex post short UIP regressions. We present evidence on ex post validity of long run UIP and strikingly new evidence on the stationarity of the long forward exchange rates of major currencies. We set up, calibrate and simulate a stylized model that well captures the observed properties of spot exchange rates and UIP regressions of major currencies. We define the notion of yield parity and test its empirical performance for monthly series of major currencies with favorable results.

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Paper provided by Netherlands Central Bank, Research Department in its series DNB Working Papers with number 098.

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Date of creation: Apr 2006
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Handle: RePEc:dnb:dnbwpp:098

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Related research
Keywords: EHTS; forward discount bias; stationarity of long maturity forward rates; UIP; yield parity;

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Find related papers by JEL classification:
E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Determination of Interest Rates; Term Structure of Interest Rates
F31 - International Economics - - International Finance - - - Foreign Exchange

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