Effects of Uncertainty on Interest Rate Parity in Central and Eastern European Economies After the Global Financial Crisis

This paper examines the role of uncertainty in explaining the Uncovered Interest Parity (UIP) puzzle in Central and Eastern European (CEE) economies from 2008 to 2022. We investigate the UIP puzzle in four CEE economies: the Czech Republic, Hungary, Poland, and Romania. First, using the baseline Fama regression, we check if the UIP condition is satisfied. In the second model, regressions associated with uncertainty variables, such as Economic Policy Uncertainty and the World Uncertainty Index, are performed. Finally, using local projections models, we check how the UIP premium reacts dynamically to uncertainty shocks. The first finding is that the UIP condition holds better for the US dollar as the reference currency and that the UIP puzzle is more pronounced in a longer time horizon. Second, during periods of heightened uncertainty, for USD-based regressions, investors demand higher excess returns. Third, the dynamic responses of the UIP premium to uncertainty shocks prove that, for USD-based models, excess returns tend to increase in the short run before exhibiting a reversal effect after 12 months. In contrast, in EUR-based models, the UIP premium remains stable at around zero. In general, the results suggest that uncertainty has a significant impact on the UIP puzzle in CEE economies when the US dollar is used as the reference currency.