Exchange Rate Uncertainty and the Interest Rate Parity

This paper studies the effect of exchange rate uncertainty on the deviations of Covered Interest Rate parity for benchmark bank rates and government yields. I develop a method for estimating the daily uncertainty from an endogenous factor clustering method to determine the currency grouping and an optimal number of groups and general factors explaining the data. I find that there are defined clusters of exchange rates that remain even after a structural change in the financial crisis and follow geographical characteristics. The deviations from the bank rates and governments differ in form and dependency, where factors such as interest rates and fluctuations in the overall dollar exchange have a substantial effect. I show that the exchange rate uncertainty increases the deviations of parity and the convenience yield of the US bond and treasury yields and that the effect is economically significant.