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Uncovered Interest Rate Parity Over the Past Two Centuries

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  • James R. Lothian

    (Fordham University)

  • Liuren Wu

    (Baruch College-CUNY)

Abstract

Uncovered interest rate parity (UIP) is one of three key theoretical relations used in analytical work in both international finance and international monetary economics. The problem, however, is that UIP does not seem to hold up well empirically. In this paper, we argue that the failures of UIP that have been so widely documented are a coincidence of two empirical artifacts: (1) the unique sample period of the 1980s and (2) the noise induced by small UIP deviations. We control for these empirical artifacts by constructing an ultra long time series that spans two centuries and by running regressions conditional on large deviations from UIP. We find that traditional regressions yield positive slpe estimates over the whole sample period and become negative only when the sample is dominated by the period of the 1980s. We argue that the negative estimates during this sample period are mainly the result of a failure of expectations to adjust quickly to the regime changes in monetary policy that took place in both the United Kingdom and the United States. We also find that large interest rate differentials have significantly stronger forecasting powers for currency movements than small interest rate differentials. Finally, a historical account of expected and realized regime changes further illustrates how the expectation hypothesis holds over the very long haul but can be deviated from for a long period of time due to slow adjustment of expectations to actual regime changes or to anticipations for extended periods of regime changes or other big events that never materialize.

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Bibliographic Info

Paper provided by EconWPA in its series International Finance with number 0311009.

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Length: 39 pages
Date of creation: 12 Nov 2003
Date of revision:
Handle: RePEc:wpa:wuwpif:0311009

Note: Type of Document - ; pages: 39
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Web page: http://128.118.178.162

Related research

Keywords: Uncovered interest rate parity; expectation hypothesis; regime changes; small sample problem; Peso problem; extreme sampling;

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References

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