IDEAS home Printed from https://ideas.repec.org/p/ces/ceswps/_9027.html
   My bibliography  Save this paper

Testing for UIP: Nonlinearities, Monetary Announcements and Interest Rate Expectations

Author

Listed:
  • Christina Anderl
  • Guglielmo Maria Caporale

Abstract

This paper re-examines the UIP relation by estimating first a benchmark linear Cointegrated VAR including the nominal exchange rate and the interest rate differential as well as central bank announcements, and then a Cointegrated Smooth Transition VAR (CVSTAR) model incorporating nonlinearities and also taking into account the role of interest rate expectations. The analysis is conducted for five inflation targeting countries (the UK, Canada, Australia, New Zealand and Sweden) and three non-targeters (the US, the Euro-Area and Switzerland) using daily data from January 2000 to December 2020. We find that the nonlinear framework is more appropriate to capture the adjustment towards the UIP equilibrium, since the estimated speed of adjustment is substantially faster and the short-run dynamic linkages are stronger. Further, interest rate expectations play an important role: a fast adjustment only occurs when the market expects the interest rate to increase in the near future, namely central banks are perceived as more credible when sticking to their goal of keeping inflation at a low and stable rate. Also, central bank announcements have a more sizeable short-run effect in the nonlinear model. Finally, UIP holds better in inflation targeting countries, where monetary authorities appear to achieve a higher degree of credibility.

Suggested Citation

  • Christina Anderl & Guglielmo Maria Caporale, 2021. "Testing for UIP: Nonlinearities, Monetary Announcements and Interest Rate Expectations," CESifo Working Paper Series 9027, CESifo.
    • Handle: RePEc:ces:ceswps:_9027
    as

    Download full text from publisher

    File URL: https://www.cesifo.org/DocDL/cesifo1_wp9027.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Salisu, Afees A. & Vo, Xuan Vinh, 2020. "Predicting stock returns in the presence of COVID-19 pandemic: The role of health news," International Review of Financial Analysis, Elsevier, vol. 71(C).
    2. Clarida, Richard H. & Sarno, Lucio & Taylor, Mark P. & Valente, Giorgio, 2003. "The out-of-sample success of term structure models as exchange rate predictors: a step beyond," Journal of International Economics, Elsevier, vol. 60(1), pages 61-83, May.
    3. Maurice Obstfeld, 1987. "Peso Problems, Bubbles, and Risk in the Empirical Assessment of Exchange-Rate Behavior," NBER Working Papers 2203, National Bureau of Economic Research, Inc.
    4. Lucio Sarno & Giorgio Valente & Hyginus Leon, 2006. "Nonlinearity in Deviations from Uncovered Interest Parity: An Explanation of the Forward Bias Puzzle," Review of Finance, European Finance Association, vol. 10(3), pages 443-482, September.
    5. Ellis Connolly & Marion Kohler, 2004. "News and Interest Rate Expectations: A Study of Six Central Banks," RBA Annual Conference Volume (Discontinued), in: Christopher Kent & Simon Guttmann (ed.),The Future of Inflation Targeting, Reserve Bank of Australia.
    6. Coulibaly, Dramane & Kempf, Hubert, 2019. "Inflation targeting and the forward bias puzzle in emerging countries," Journal of International Money and Finance, Elsevier, vol. 90(C), pages 19-33.
    7. Jiang, Chun & Li, Xiao-Lin & Chang, Hsu-Ling & Su, Chi-Wei, 2013. "Uncovered interest parity and risk premium convergence in Central and Eastern European countries," Economic Modelling, Elsevier, vol. 33(C), pages 204-208.
    8. Mr. Abhisek Banerjee & Mr. Manmohan Singh, 2006. "Testing Real Interest Parity in Emerging Markets," IMF Working Papers 2006/249, International Monetary Fund.
    9. Allan W. Gregory, 1987. "Testing Interest Rate Parity and Rational Expectations for Canada and the United States," Canadian Journal of Economics, Canadian Economics Association, vol. 20(2), pages 289-305, May.
    10. Unknown, 2005. "Forward," 2005 Conference: Slovenia in the EU - Challenges for Agriculture, Food Science and Rural Affairs, November 10-11, 2005, Moravske Toplice, Slovenia 183804, Slovenian Association of Agricultural Economists (DAES).
    11. Lothian, James R. & Wu, Liuren, 2011. "Uncovered interest-rate parity over the past two centuries," Journal of International Money and Finance, Elsevier, vol. 30(3), pages 448-473, April.
    12. Lothian, James R., 2016. "Uncovered interest parity: The long and the short of it," Journal of Empirical Finance, Elsevier, vol. 36(C), pages 1-7.
    13. 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.
    14. Lucio Sarno, 2005. "Viewpoint: Towards a solution to the puzzles in exchange rate economics: where do we stand?," Canadian Journal of Economics, Canadian Economics Association, vol. 38(3), pages 673-708, August.
    15. Eitrheim, Oyvind & Terasvirta, Timo, 1996. "Testing the adequacy of smooth transition autoregressive models," Journal of Econometrics, Elsevier, vol. 74(1), pages 59-75, September.
    16. Moore, Michael J. & Roche, Maurice J., 2010. "Solving exchange rate puzzles with neither sticky prices nor trade costs," Journal of International Money and Finance, Elsevier, vol. 29(6), pages 1151-1170, October.
    17. Timo Teräsvirta & Yukai Yang, 2014. "Linearity and Misspecification Tests for Vector Smooth Transition Regression Models," CREATES Research Papers 2014-04, Department of Economics and Business Economics, Aarhus University.
    18. Carlo Rosa & Giovanni Verga, 2008. "The Impact of Central Bank Announcements on Asset Prices in Real Time," International Journal of Central Banking, International Journal of Central Banking, vol. 4(2), pages 175-217, June.
    19. Ignacio Mauleón, 1998. "Interest rate expectations and the exchange rate," International Advances in Economic Research, Springer;International Atlantic Economic Society, vol. 4(2), pages 179-191, May.
    20. Baillie, Richard T. & Chang, Sanders S., 2011. "Carry trades, momentum trading and the forward premium anomaly," Journal of Financial Markets, Elsevier, vol. 14(3), pages 441-464, August.
    21. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-192, Summer.
    22. Timothy Q. Cook & Thomas K. Hahn, 1990. "Interest rate expectations and the slope of the money market yield curve," Economic Review, Federal Reserve Bank of Richmond, vol. 76(Sep), pages 3-26.
    23. Li, Dandan & Ghoshray, Atanu & Morley, Bruce, 2013. "An empirical study of nonlinear adjustment in the UIP model using a smooth transition regression model," International Review of Financial Analysis, Elsevier, vol. 30(C), pages 109-120.
    24. Sager, Michael J. & Taylor, Mark P., 2004. "The impact of European Central Bank Governing Council announcements on the foreign exchange market: a microstructural analysis," Journal of International Money and Finance, Elsevier, vol. 23(7-8), pages 1043-1051.
    25. Manfred J. M. Neumann & Jurgen Von Hagen, 2002. "Does inflation targeting matter?," Review, Federal Reserve Bank of St. Louis, vol. 84(Jul), pages 127-148.
    26. Sofiane Amri, 2008. "Analysing the forward premium anomaly using a Logistic Smooth Transition Regression model," Economics Bulletin, AccessEcon, vol. 6(26), pages 1-18.
    27. Zivot, Eric, 2000. "Cointegration and forward and spot exchange rate regressions," Journal of International Money and Finance, Elsevier, vol. 19(6), pages 785-812, December.
    28. Arghyrou, Michael G. & Pourpourides, Panayiotis, 2016. "Inflation announcements and asymmetric exchange rate responses," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 40(C), pages 80-84.
    29. Álvaro Escribano & Oscar Jordá, 2001. "Testing nonlinearity: Decision rules for selecting between logistic and exponential STAR models," Spanish Economic Review, Springer;Spanish Economic Association, vol. 3(3), pages 193-209.
    30. Enzo Weber, 2006. "British Interest Rate Convergence Between The Us And Europe: A Recursive Cointegration Analysis," The IUP Journal of Monetary Economics, IUP Publications, vol. 0(4), pages 29-47, November.
    31. Johansen, Søren & Juselius, Katarina, 1992. "Testing structural hypotheses in a multivariate cointegration analysis of the PPP and the UIP for UK," Journal of Econometrics, Elsevier, vol. 53(1-3), pages 211-244.
    32. Li, Dandan & Ghoshray, Atanu & Morley, Bruce, 2012. "Measuring the risk premium in uncovered interest parity using the component GARCH-M model," International Review of Economics & Finance, Elsevier, vol. 24(C), pages 167-176.
    33. Ripatti, Antti & , Pentti, 2001. "Vector Autoregressive Processes With Nonlinear Time Trends In Cointegrating Relations," Macroeconomic Dynamics, Cambridge University Press, vol. 5(4), pages 577-597, September.
    34. repec:ebl:ecbull:v:6:y:2008:i:26:p:1-18 is not listed on IDEAS
    35. Brenner, Robin J. & Kroner, Kenneth F., 1995. "Arbitrage, Cointegration, and Testing the Unbiasedness Hypothesis in Financial Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 30(1), pages 23-42, March.
    36. Juselius, Katarina & Stillwagon, Josh R., 2018. "Are outcomes driving expectations or the other way around? An I(2) CVAR analysis of interest rate expectations in the dollar/pound market," Journal of International Money and Finance, Elsevier, vol. 83(C), pages 93-105.
    37. Miguel Lacerda & Johannes W. Fedderke & Linda M. Haines, 2010. "Testing For Purchasing Power Parity And Uncovered Interest Parity In The Presence Of Monetary And Exchange Rate Regime Shifts," South African Journal of Economics, Economic Society of South Africa, vol. 78(4), pages 363-382, December.
    38. Georgoutsos D. & Kouretas G., 2002. "Cointegration, Uncoverd Interest Parity and the Term Structure of Interest Rates: Some International Evidence," European Research Studies Journal, European Research Studies Journal, vol. 0(1-2), pages 7-22, January -.
    39. Menzie D. Chinn & Saad Quayyum, 2012. "Long Horizon Uncovered Interest Parity Re-Assessed," NBER Working Papers 18482, National Bureau of Economic Research, Inc.
    40. Richard H. Clarida & Mark P. Taylor, 1997. "The Term Structure Of Forward Exchange Premiums And The Forecastability Of Spot Exchange Rates: Correcting The Errors," The Review of Economics and Statistics, MIT Press, vol. 79(3), pages 353-361, August.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Christina Anderl & Guglielmo Maria Caporale, 2022. "Testing for UIP-Type Relationships: Nonlinearities, Monetary Announcements and Interest Rate Expectations," Open Economies Review, Springer, vol. 33(4), pages 705-749, September.
    2. Wagner, Christian, 2012. "Risk-premia, carry-trade dynamics, and economic value of currency speculation," Journal of International Money and Finance, Elsevier, vol. 31(5), pages 1195-1219.
    3. Christina Anderl & Guglielmo Maria Caporale, 2022. "Exchange rate parities and Taylor rule deviations," Empirical Economics, Springer, vol. 63(4), pages 1809-1835, October.
    4. C. Emre Alper & Oya Pinar Ardic & Salih Fendoglu, 2009. "The Economics Of The Uncovered Interest Parity Condition For Emerging Markets," Journal of Economic Surveys, Wiley Blackwell, vol. 23(1), pages 115-138, February.
    5. Hochradl, Markus & Wagner, Christian, 2010. "Trading the forward bias: Are there limits to speculation?," Journal of International Money and Finance, Elsevier, vol. 29(3), pages 423-441, April.
    6. Michael D. Goldberg & Olesia Kozlova & Deniz Ozabaci, 2020. "Forward Rate Bias in Developed and Developing Countries: More Risky Not Less Rational," Econometrics, MDPI, vol. 8(4), pages 1-26, December.
    7. Kumar, Satish, 2019. "Does risk premium help uncover the uncovered interest parity failure?," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 63(C).
    8. repec:onb:oenbwp:y::i:143:b:1 is not listed on IDEAS
    9. Snaith, Stuart & Coakley, Jerry & Kellard, Neil, 2013. "Does the forward premium puzzle disappear over the horizon?," Journal of Banking & Finance, Elsevier, vol. 37(9), pages 3681-3693.
    10. Chinn, Menzie D., 2006. "The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 7-21, February.
    11. Pippenger, John, 2017. "Forward Bias, The Failure Of Uncovered Interest Parity And Related Puzzles," University of California at Santa Barbara, Economics Working Paper Series qt2ff194s2, Department of Economics, UC Santa Barbara.
    12. Antonio Diez De Los Rios, 2009. "Can Affine Term Structure Models Help Us Predict Exchange Rates?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(4), pages 755-766, June.
    13. Kearney, Fearghal & Cummins, Mark & Murphy, Finbarr, 2019. "Using extracted forward rate term structure information to forecast foreign exchange rates," Journal of Empirical Finance, Elsevier, vol. 53(C), pages 1-14.
    14. Adewuyi, Adeolu O. & Ogebe, Joseph O., 2019. "The validity of uncovered interest parity: Evidence from african members and non-member of the organisation of petroleum exporting countries (OPEC)," Economic Modelling, Elsevier, vol. 82(C), pages 229-249.
    15. Stocker, Marshall L., 2016. "The price of freedom: Idiosyncratic currency devaluations," Research in International Business and Finance, Elsevier, vol. 38(C), pages 312-325.
    16. Juan Carlos Cuestas & Fabio Filipozzi & Karsten Staehr, 2017. "Uncovered interest parity in Central and Eastern Europe: Expectations and structural breaks," Review of International Economics, Wiley Blackwell, vol. 25(4), pages 695-710, September.
    17. Pippenger, John, 2018. "Forward Bias, Uncovered Interest Parity and Related Puzzles," University of California at Santa Barbara, Economics Working Paper Series qt2cm6p186, Department of Economics, UC Santa Barbara.
    18. Sofiane Amri, 2008. "Analysing the forward premium anomaly using a Logistic Smooth Transition Regression model," Economics Bulletin, AccessEcon, vol. 6(26), pages 1-18.
    19. Pasricha, Gurnain Kaur, 2006. "Survey of Literature on Covered and Uncovered Interest Parities," MPRA Paper 22737, University Library of Munich, Germany.
    20. Cheung, Yin-Wong & Wang, Wenhao, 2022. "Uncovered interest rate parity redux: Non-uniform effects," Journal of Empirical Finance, Elsevier, vol. 67(C), pages 133-151.
    21. Brian Lucey & Grace Loring, 2012. "Forward Exchange Rate Biasedness across Developed and Developing Country Currencies - Do Observed Patterns Persist Out of Sample?Abstract:," The Institute for International Integration Studies Discussion Paper Series iiisdp404, IIIS.

    More about this item

    Keywords

    UIP; exchange rate; nonlinearities; asymmetric adjustment; CVAR (Cointegrated VAR); CVSTAR (Cointegrated Smooth Transition VAR); interest rate expectations; interest rate announcements;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ces:ceswps:_9027. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Klaus Wohlrabe (email available below). General contact details of provider: https://edirc.repec.org/data/cesifde.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.