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Tests of Three Parity Conditions: Distinguishing Risk Premia and Systematic Forecast Errors

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  • Richard C. Marston
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    Abstract

    Two explanations are given for why nominal or real returns differ across currencies: foreign exchange risk premia and systematic (rational) forecast errors. This study reexamines three parity conditions in international finance, uncovered interest parity, purchasing power parity, and real interest parity, to determine the relative importance of these two factors. The study develops joint tests of the three parity conditions by relating nominal and real interest differentials and inflation differentials to the same set of variables currently known to investors. The study tests parameter restrictions based on knowing that risk premiums only affect nominal and real interest differentials, but not inflation differentials, while systematic errors in forecasting exchange rates only affect nominal interest differentials and inflation differentials, but not real interest differentials.

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    File URL: http://www.nber.org/papers/w4923.pdf
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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4923.

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    Date of creation: Nov 1994
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    Publication status: published as Journal of International Money and Finance, Vol. 16, no. 2 (April 1997): 285-303.
    Handle: RePEc:nbr:nberwo:4923

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    1. Mishkin, Frederic S, 1984. " Are Real Interest Rates Equal across Countries? An Empirical Investigation of International Parity Conditions," Journal of Finance, American Finance Association, vol. 39(5), pages 1345-57, December.
    2. 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.
    3. Jeffrey A. Frankel, 1985. "International capital mobility and crowding-out in the U.S. economy: imperfect integration of financial markets or of goods markets?," Proceedings, Federal Reserve Bank of St. Louis, pages 33-74.
    4. Kester, W. Carl & Luehrman, Timothy A., 1989. "Real interest rates and the cost of capital : A comparison of the United States and Japan," Japan and the World Economy, Elsevier, vol. 1(3), pages 279-301, July.
    5. Adler, Michael & Dumas, Bernard, 1983. " International Portfolio Choice and Corporation Finance: A Synthesis," Journal of Finance, American Finance Association, vol. 38(3), pages 925-84, June.
    6. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-92, Summer.
    7. Cumby, Robert E. & Huizinga, John, 1992. "Investigating the correlation of unobserved expectations : Expected returns in equity and foreign exchange markets and other examples," Journal of Monetary Economics, Elsevier, vol. 30(2), pages 217-253, November.
    8. Robert N. McCauley & Steven A. Zimmer, 1989. "Explaining international differences in the cost of capital," Quarterly Review, Federal Reserve Bank of New York, issue Sum, pages 7-28.
    9. Lothian, James R. & Taylor, Mark P., 1997. "Real exchange rate behavior," Journal of International Money and Finance, Elsevier, vol. 16(6), pages 945-954, December.
    10. Lewis, K.K., 1994. "Puzzles in international Financial Markets," Weiss Center Working Papers 94-7, Wharton School - Weiss Center for International Financial Research.
    11. Shiller, Robert J, 1979. "The Volatility of Long-Term Interest Rates and Expectations Models of the Term Structure," Journal of Political Economy, University of Chicago Press, vol. 87(6), pages 1190-1219, December.
    12. Karen K. Lewis, 1994. "Puzzles in International Financial Markets," NBER Working Papers 4951, National Bureau of Economic Research, Inc.
    13. Robert J. Shiller & John Y. Campbell & Kermit L. Schoenholtz, 1983. "Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates," Cowles Foundation Discussion Papers 667, Cowles Foundation for Research in Economics, Yale University.
    14. Lewis, Karen K, 1989. "Changing Beliefs and Systematic Rational Forecast Errors with Evidence from Foreign Exchange," American Economic Review, American Economic Association, vol. 79(4), pages 621-36, September.
    15. John Huizinga & Frederic S. Mishkin, 1984. "Inflation and Real Interest Rates on Assets with Different Risk Characteristics," NBER Working Papers 1333, National Bureau of Economic Research, Inc.
    16. Geert Bekaert & Robert J. Hodrick, 1991. "Characterizing Predictable Components in Excess Returns on Equity and Foreign Exchange Markets," NBER Working Papers 3790, National Bureau of Economic Research, Inc.
    17. Dutton, Marilyn Miller, 1993. "Real interest rate parity new measures and tests," Journal of International Money and Finance, Elsevier, vol. 12(1), pages 62-77, February.
    18. Mark, Nelson C., 1985. "Some evidence on the international inequality of real interest rates," Journal of International Money and Finance, Elsevier, vol. 4(2), pages 189-208, June.
    19. Abuaf, Niso & Jorion, Philippe, 1990. " Purchasing Power Parity in the Long Run," Journal of Finance, American Finance Association, vol. 45(1), pages 157-74, March.
    20. Adler, Michael & Lehmann, Bruce, 1983. " Deviations from Purchasing Power Parity in the Long Run," Journal of Finance, American Finance Association, vol. 38(5), pages 1471-87, December.
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    Cited by:
    1. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
    2. George Furstenberg, 1998. "From Worldwide Capital Mobility to International Financial Integration: A Review Essay," Open Economies Review, Springer, vol. 9(1), pages 53-84, January.

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