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Uncovered Interest Rate Parity Over the Past Two Centuries

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Author Info
James R. Lothian (Fordham University)
Liuren Wu (Baruch College-CUNY)

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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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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
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Handle: RePEc:wpa:wuwpif:0311009

Note: Type of Document - ; pages: 39
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Related research
Keywords: Uncovered interest rate parity; expectation hypothesis; regime changes; small sample problem; Peso problem; extreme sampling;

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Waldenström, Daniel, 2005. "Does Sovereign Risk Differ for Domestic and Foreign Investors? Historical Evidence from Scandinavian Bond Markets," Working Paper Series in Economics and Finance 585, Stockholm School of Economics, revised 18 Feb 2005. [Downloadable!]
  2. Dees, S. & Holly, S. & Pesaran, M.H. & Smith, L.V., 2007. "Long Run Macroeconomic Relations in the Global Economy," Cambridge Working Papers in Economics 0703, Faculty of Economics, University of Cambridge. [Downloadable!]
    Other versions:
  3. Alex Luiz Ferreira, 2004. "Leaning Against the Parity," Studies in Economics 0413, Department of Economics, University of Kent. [Downloadable!]
  4. Campbell, Rachel & Koedijk, Kees & Lothian, James R & Mahieu, Ronald J, 2007. "Irving Fisher, Expectational Errors, and the UIP Puzzle," CEPR Discussion Papers 6294, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  5. Campbell-Pownall, R.A.J. & Koedijk, C.G. & Lothian, J.R. & Mahieu, R.J., 2007. "Irving Fisher and the UIP Puzzle: Meeting the Expectations a Century Later," Research Paper ERS-2007-088-F&A Revision, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni. [Downloadable!]
  6. Christophe Chamley, 2006. "Complementarities in information acquisition with short-term trades," Boston University - Department of Economics - Working Papers Series WP2006-042, Boston University - Department of Economics. [Downloadable!]
  7. Antonio Diez de los Rios, 2006. "Can Affine Term Structure Models Help Us Predict Exchange Rates?," Working Papers 06-27, Bank of Canada. [Downloadable!]
    Other versions:
  8. Eliane Cristina de Araujo & Marcos Vinicius Chiliatto Leite, 2009. "Sobreapreciação Cambial no Brasil: Estimativa, Causas e Consequências (1994-2008)," Discussion Papers 1404, Instituto de Pesquisa Econômica Aplicada - IPEA. [Downloadable!]
  9. Rui Albuquerque, 2004. "The Forward Premium Puzzle in a Model of Imperfect Information: Theory and Evidence," International Finance 0405007, EconWPA. [Downloadable!]
  10. Jaehun Chung & Yongmiao Hong, 2007. "Model-free evaluation of directional predictability in foreign exchange markets," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 22(5), pages 855-889. [Downloadable!]
  11. Metodij Hadzi-Vaskov & Clemens Kool, 2006. "The Importance of Interest Rate Volatility in Empirical Tests of Uncovered Interest Parity," Working Papers 06-16, Utrecht School of Economics. [Downloadable!]
  12. Waldenström, Daniel, 2006. "Why Does Sovereign Risk Differ for Domestic and Foreign Investors? Evidence from Scandinavia, 1938­­–1948," Working Paper Series 677, Research Institute of Industrial Economics. [Downloadable!]
  13. Erdemlioglu, Deniz M, 2007. "A new Test of Uncovered Interest Rate Parity: Evidence from Turkey," MPRA Paper 10787, University Library of Munich, Germany. [Downloadable!]
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