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A Reconsideration of the Uncovered Interest Parity Relationship

  • Bennett T. McCallum

The paper first presents reasons for viewing the uncovered interest-parity (VIP) relationship as more important, in terms of economic analysis, than the unbiasedness of forward rates as predictors of future spot exchange rates. The two hypotheses are closely related, so that test rejections of the latter tend to cast doubt on the former, but are not identical--so unbiasedness rejections are not conclusive for UIP. Next, some representative evidence is presented that pertains to alternative versions of the unbiasedness test. Although s[sub t] = [alpha] + ([beta]f[sub t- 1] + [epsilon, sub t] and s[sub t] - s[sub t-1] =[alpha] + [beta](f[sub t-1] ? s[sub t-1]) + [epsilon, sub t] are equivalent under the null hypothesis of [beta]= 1.0, they represent different classes of alternative hypotheses. Empirically, they give rise to extremely different outcomes, estimates of [beta] being very close to 1. 0 in the former equation but in the vicinity of -3.0 in the latter. In a generalized specification that includes both as special cases, the results strongly favor the second specification--thereby rejecting unbiasedness. Finally, three possible explanations for the [beta] = -3 result are considered and related to the UIP condition. Of these three, the latter two--one involving systematically irrational expectations and the other an additional relationship reflecting monetary policy behavior--are consistent with UIP. The policy-response hypothesis, that monetary authorities manage interest-rate differentials so as to resist rapid changes in exchange rates and in these differentials, is attractive conceptually and is capable of explaining not only the [beta] = -3 finding, but also several other notable features of the data.

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File URL: http://www.nber.org/papers/w4113.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4113.

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Date of creation: Jul 1992
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Publication status: published as Journal of Monetary Economics, vol. 33, (1994), pp 105-132
Handle: RePEc:nbr:nberwo:4113
Note: ME IFM
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  1. Meese, Richard A & Singleton, Kenneth J, 1982. " On Unit Roots and the Empirical Modeling of Exchange Rates," Journal of Finance, American Finance Association, vol. 37(4), pages 1029-35, September.
  2. Froot, Kenneth A & Frankel, Jeffrey A, 1989. "Forward Discount Bias: Is It an Exchange Risk Premium?," The Quarterly Journal of Economics, MIT Press, vol. 104(1), pages 139-61, February.
  3. Bekaert, Geert & Hodrick, Robert J., 1993. "On biases in the measurement of foreign exchange risk premiums," Journal of International Money and Finance, Elsevier, vol. 12(2), pages 115-138, April.
  4. John F. O. Bilson, 1980. "The "Speculative Efficiency" Hypothesis," NBER Working Papers 0474, National Bureau of Economic Research, Inc.
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  7. Pope, Peter F. & Peel, David A., 1991. "Forward foreign exchange rates and risk premia--a reappraisal," Journal of International Money and Finance, Elsevier, vol. 10(3), pages 443-456, September.
  8. Taylor, John B, 1989. "Monetary Policy and the Stability of Macroeconomic Relationships," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 4(S), pages S161-78, Supplemen.
  9. Frankel, Jeffrey A & Froot, Kenneth A, 1987. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," American Economic Review, American Economic Association, vol. 77(1), pages 133-53, March.
  10. Frenkel, Jacob A & Mussa, Michael L, 1980. "The Efficiency of Foreign Exchange Markets and Measures of Turbulence," American Economic Review, American Economic Association, vol. 70(2), pages 374-81, May.
  11. Barnhart, Scott W. & Szakmary, Andrew C., 1991. "Testing the Unbiased Forward Rate Hypothesis: Evidence on Unit Roots, Co-Integration, and Stochastic Coefficients," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 26(02), pages 245-267, June.
  12. Boyer, Russell S & Adams, F Charles, 1988. "Forward Premia and Risk Premia in a Simple Model of Exchange Rate Determination," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(4), pages 633-44, November.
  13. Hansen, Lars Peter & Hodrick, Robert J, 1980. "Forward Exchange Rates as Optimal Predictors of Future Spot Rates: An Econometric Analysis," Journal of Political Economy, University of Chicago Press, vol. 88(5), pages 829-53, October.
  14. Robert E. Cumby & Maurice Obstfeld, 1982. "International Interest-Rate and Price-Level Linkages Under Flexible Exchange Rates: A Review of Recent Evidence," NBER Working Papers 0921, National Bureau of Economic Research, Inc.
  15. Longworth, David, 1981. "Testing the Efficiency of the Canadian-U.S. Exchange Market under the Assumption of no Risk Premium," Journal of Finance, American Finance Association, vol. 36(1), pages 43-49, March.
  16. Fratianni, Michele & Wakeman, L. MacDonald, 1982. "The law of one price in the eurocurrency market," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 307-323, January.
  17. Ralph Tryon, 1979. "Testing for rational expectations in foreign exchange markets," International Finance Discussion Papers 139, Board of Governors of the Federal Reserve System (U.S.).
  18. Jacob A. Frenkel & Michael L. Mussa, 1980. "Efficiency of Foreign Exchange Markets and Measures of Turbulence," NBER Working Papers 0476, National Bureau of Economic Research, Inc.
  19. Levich, Richard M., 1985. "Empirical studies of exchange rates: Price behavior, rate determination and market efficiency," Handbook of International Economics, in: R. W. Jones & P. B. Kenen (ed.), Handbook of International Economics, edition 1, volume 2, chapter 19, pages 979-1040 Elsevier.
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