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Use of (Time-Domain) Vector Autoregressions to Test Uncovered Interest Parity

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  • Takatoshi Ito

Abstract

In this paper, a vector autoregression model (VAR) is proposed in order to test uncovered interest parity (UIP) in the foreign exchange market. Consider a VAR system of the spot exchange rate (yen/dollar), the domestic (US) interest rate and the foreign (Japanese) interest rate, describing the interdependence of the domestic and international financia lmarkets. Uncovered interest parity is stated as a null hypothesis that the current difference between the two interest rates is equal to the difference between the expected future (log of) exchange rate and the (log of) current spot exchange rate. Note that the VAR system will yield the expected future spot exchange rate as a k-step ahead unconditional prediction. Hence, the null hypothesis is stated as nonlinear cross-equational restrictions for the three-equation VAR system. Then UIP is tested by the Wald test between the unrestricted and restricted systems. A test of UIP with a maintained hypothesis of covered interest parity, becomes a hypothesis test of efficiency without risk premium, that is,the forward exchange rate isthe unbiased predictor of the future spot exchange rate, and information is efficiently used in its prediction. Our results are compared to the efficiency test with a single equation using the Hansen-Hodrick procedure for the same data set.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1493.

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Date of creation: Nov 1984
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Publication status: published as The Review of Economics and Statistics, Vol. LXX, No. 2, (May 1988), pp. 29 6-305.
Handle: RePEc:nbr:nberwo:1493

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  1. Craig S. Hakkio, 1979. "The Term Structure of the Forward Premium," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 404, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  2. Baillie, Richard T & Lippens, Robert E & McMahon, Patrick C, 1983. "Testing Rational Expectations and Efficiency in the Foreign Exchange Market," Econometrica, Econometric Society, Econometric Society, vol. 51(3), pages 553-63, May.
  3. Richard Meese & Kenneth Rogoff & Jacob Frenkel, . "The Out-of-Sample Failure of Empirical Exchange Rate Models: Sampling Error or Misspecification?," Working Paper 32044, Harvard University OpenScholar.
  4. Sargent, Thomas J, 1984. "Autoregressions, Expectations, and Advice," American Economic Review, American Economic Association, American Economic Association, vol. 74(2), pages 408-15, May.
  5. Takatoshi Ito, 1983. "Capital Controls and Covered Interest Parity," NBER Working Papers 1187, National Bureau of Economic Research, Inc.
  6. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, Econometric Society, vol. 48(1), pages 1-48, January.
  7. Robert E. Cumby & Maurice Obstfeld, 1984. "International Interest Rate and Price Level Linkages under Flexible Exchange Rates: A Review of Recent Evidence," NBER Chapters, in: Exchange Rate Theory and Practice, pages 121-152 National Bureau of Economic Research, Inc.
  8. Gregory, Allan W. & McCurdy, Thomas H., 1984. "Testing the unbiasedness hypothesis in the forward foreign exchange market: A specification analysis," Journal of International Money and Finance, Elsevier, Elsevier, vol. 3(3), pages 357-368, December.
  9. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, Econometric Society, vol. 50(4), pages 1029-54, July.
  10. Thomas J. Sargent, 1978. "A note on maximum likelihood estimation of the rational expectations model of the term structure," Staff Report, Federal Reserve Bank of Minneapolis 26, Federal Reserve Bank of Minneapolis.
  11. Lars Peter Hansen & Thomas J. Sargent, 1981. "Exact linear rational expectations models: specification and estimation," Staff Report, Federal Reserve Bank of Minneapolis 71, Federal Reserve Bank of Minneapolis.
  12. Frenkel, Jacob A, 1977. "The Forward Exchange Rate, Expectations, and the Demand for Money: The German Hyperinflation," American Economic Review, American Economic Association, American Economic Association, vol. 67(4), pages 653-70, September.
  13. Hodrick, Robert J. & Srivastava, Sanjay, 1984. "An investigation of risk and return in forward foreign exchange," Journal of International Money and Finance, Elsevier, Elsevier, vol. 3(1), pages 5-29, April.
  14. Longworth, David, 1981. "Testing the Efficiency of the Canadian-U.S. Exchange Market under the Assumption of no Risk Premium," Journal of Finance, American Finance Association, American Finance Association, vol. 36(1), pages 43-49, March.
  15. Cornell, Bradford, 1977. "Spot rates, forward rates and exchange market efficiency," Journal of Financial Economics, Elsevier, Elsevier, vol. 5(1), pages 55-65, August.
  16. Geweke, John F & Feige, Edgar L, 1979. "Some Joint Tests of the Efficiency of Markets for Forward Foreign Exchange," The Review of Economics and Statistics, MIT Press, vol. 61(3), pages 334-41, August.
  17. Frenkel, Jacob A, 1981. "Flexible Exchange Rates, Prices, and the Role of "News": Lessons from the 1970s," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 89(4), pages 665-705, August.
  18. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 88(5), pages 829-53, October.
  19. Hodrick, Robert J., 1981. "International asset pricing with time-varying risk premia," Journal of International Economics, Elsevier, Elsevier, vol. 11(4), pages 573-587, November.
  20. Lars Peter Hansen & Robert J. Hodrick, 1983. "Risk Averse Speculation in the Forward Foreign Exchange Market: An Econometric Analysis of Linear Models," NBER Chapters, in: Exchange Rates and International Macroeconomics, pages 113-152 National Bureau of Economic Research, Inc.
  21. Frenkel, Jacob A., 1979. "Further evidence on expectations and the demand for money during the German hyperinflation," Journal of Monetary Economics, Elsevier, Elsevier, vol. 5(1), pages 81-96, January.
  22. Christopher A. Sims, 1982. "Policy Analysis with Econometric Models," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 13(1), pages 107-164.
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Cited by:
  1. Takatoshi Ito & V. Vance Roley, 1986. "News from the U.S. and Japan: which moves the yen/dollar exchange rate?," Research Working Paper, Federal Reserve Bank of Kansas City 86-02, Federal Reserve Bank of Kansas City.
  2. John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 785, Cowles Foundation for Research in Economics, Yale University.
  3. Ito, Takatoshi, 1990. "Foreign Exchange Rate Expectations: Micro Survey Data," American Economic Review, American Economic Association, American Economic Association, vol. 80(3), pages 434-49, June.
  4. Jeffrey A. Frankel., 1993. "Is Japan Creating a Yen Bloc in East Asia and the Pacific?," Center for International and Development Economics Research (CIDER) Working Papers, University of California at Berkeley C93-007, University of California at Berkeley.
  5. Ito Takatoshi & Okina Kunio & Teranishi Juro, 1993. "News and the Dollar/Yen Exchange Rate, 1931-1933: The End of the Gold Standard, Imperialism, and the Great Depression," Journal of the Japanese and International Economies, Elsevier, vol. 7(2), pages 107-131, June.
  6. Phylaktis, Kate, 1999. "Capital market integration in the Pacific Basin region: an impulse response analysis," Journal of International Money and Finance, Elsevier, Elsevier, vol. 18(2), pages 267-287, February.
  7. Phylaktis, Kate, 1997. "Capital market integration in the Pacific-Basin region: An analysis of real interest rate linkages," Pacific-Basin Finance Journal, Elsevier, Elsevier, vol. 5(2), pages 195-213, June.
  8. Jeffrey A. Frankel & Kenneth A. Froot, 1986. "Short-term and long-term expectations of the yen/dollar exchange rate: evidence from survey data," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 292, Board of Governors of the Federal Reserve System (U.S.).
  9. V. Vance Roley, 1986. "U.S. Monetary Policy Regimes and U.S.-Japan Financial Relations," NBER Working Papers 1858, National Bureau of Economic Research, Inc.
  10. Takatoshi Ito & V. Vance Roley, 1988. "Intraday yen/dollar exchange rate movements: news or noise?," Research Working Paper, Federal Reserve Bank of Kansas City 88-07, Federal Reserve Bank of Kansas City.

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