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Exchange Rates and UIP Violations at Short and Long Horizons

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  • Rosen Valchev

    (Duke University)

Abstract

The much-studied Uncovered Interest Rate Parity (UIP) puzzle, the observation that exchange rates do not adjust sufficiently to offset interest rate differentials, is more complicated than commonly understood. It changes nature with the horizon. I confirm existing short-run evidence that high interest rate currencies depreciate less than predicted by the interest rate differential, but, building on Engel (2012), at longer horizons (4 to 7 years) I find a reverse puzzle: high interest rate currencies depreciate too much. Interestingly, the long-horizon excess depreciation leads exchange rates to converge to the UIP benchmark over the long-run. To address the changing nature of the puzzle, I propose a novel model, based on the mechanism of bond convenience yields, that can explain both the short and the long horizon UIP violations. I also provide direct empirical evidence that supports the mechanism.

Suggested Citation

  • Rosen Valchev, 2015. "Exchange Rates and UIP Violations at Short and Long Horizons," 2015 Meeting Papers 1446, Society for Economic Dynamics.
  • Handle: RePEc:red:sed015:1446
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    3. Özmen, M. Utku & Yılmaz, Erdal, 2017. "Co-movement of exchange rates with interest rate differential, risk premium and FED policy in “fragile economies”," Emerging Markets Review, Elsevier, vol. 33(C), pages 173-188.
    4. Sami Alpanda & Uluc Aysun & Serdar Kabaca, 2022. "International Portfolio Rebalancing and Fiscal Policy Spillovers," Working Papers 2022-01, University of Central Florida, Department of Economics.
    5. Serdar Kabaca, 2016. "Quantitative Easing in a Small Open Economy: An International Portfolio Balancing Approach," Staff Working Papers 16-55, Bank of Canada.
    6. Eren, Egemen & Malamud, Semyon, 2022. "Dominant currency debt," Journal of Financial Economics, Elsevier, vol. 144(2), pages 571-589.
    7. M. Utku Ozmen & Erdal Yilmaz, 2016. "Co-movement of Exchange Rates with Interest Rate Differential, Risk Premium and FED Policy in �Fragile Economies�," Working Papers 1621, Research and Monetary Policy Department, Central Bank of the Republic of Turkey.

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