As per uncovered interest parity (UIP) conditions, the difference between the interest rate of two countries equals the expected change of exchange rate between the currencies of the two countries. This means a country with higher interest rate with respect to another country is expected to depreciate in future. Absence of UIP would give birth to carry trade. Investors will borrow money from the country with lower interest rate and will invest in countries with higher interest rate due to the possibility of arbitrage. In carry trade money is borrowed in currency with low interest rate, converted to currency with high interest rate, invested in an asset with maturity date of the borrowing period, after maturity is converted back to the borrowed currency and debt is repaid. Due to the difference in exchange rate in borrowed money and invested money, the investor enjoys a surplus. Since, there is a foreign exchange risk associated with carry trade, the surplus (deficit) is considered as the risk premium. Thus, the return from arbitrage in absence of UIP has three components: a) the interest rate differential, b) spot rate change over investment period can add to or subtract from returns and c) gain or loss in funding currency has to be brought back into base currency
UIP is based on the premise of risk- neutrality and rationality. Hence, under UIP the interest rate differential is an unbiased predictor of future exchange rate. The expected future exchange ensures that the gain from interest rate difference is neutralized from the exchange rate differential.
Literature Review
Empirically, the UIP theory is usually rejected, and explanations for this rejection include that expectations are irrational whereas UIP is based on rational expectation. In 1984 Fama tested for UIP at distant horizons and found that interest rate differentials tend to be negatively, rather than positively, correlated with future currency movements, thereby wrongly predicting their direction[1]. Some of the widely accepted literature that prove absence of UIP are the publications of Frankel and Froot, Mark and Wu, Domowotz and Hakkio, Nieuwland, Bekaert and Hodrick, Baillie and Bollerslev etc. Other than irrational expectations the other reported reasons for absence of UIP are time-dependent risk premia, policy behaviour and structural parameters. McCallum has argued that monetary-policy behavior can be responsible for the apparent empirical failure of uncovered interest parity (UIP)[2]. Peter Ankel has investigated whether optimizing policy behaviour can account for the observed regime-dependence of UIP evidence[3]. In some of the literature at higher frequency doubtful statistical interference is considered as the cause of deviation from UIP. Some of the literatures have revealed that UIP holds in long horizon than short horizon (Chin and Medith-2005). Flood and Rose (2001) in their study found considerable heterogeneity across countries. Their findings detected signs that UIP at the short horizon holds better in crisis countries where exchange as well as interest rates display high volatility[4]. In the short run, a disequilibrium in the foreign exchange market leads to arbitraging opportunities. Without instantaneous adjustment a market in short-run remains in disequilibrium. Traders exploit the short run market inefficiency to generate arbitrage profits.
Studies of Cochrane (1999), Alexius (2001), Chinn (2006) and Zhang (2006) also reveal that UIP tends to hold for financial instruments of longer maturities. Lothian and Wu (2005) studied the validity of uncovered interest-rate parity (UIP) by constructing ultra long time series that span two centuries[5]. They found that The forward-premium regressions yield positive slope estimates over their whole sample period and become negative only when the sample was dominated by the period of 1980s. They also found that large interest-rate differentials have significantly stronger forecasting powers for currency movements than small interest-rate differentials. Their results indicate that uncovered interest-rate parity holds over the very long haul but can be deviated from for a long period of time due to slow adjustment of expectations to actual regime changes or to anticipations for extended periods of regime changes or other big events that never materialize.
The broadly followed specification (i.e. the approximate UIP) is usually written in the following approximate form of linear regression:
∆St+k= α+ β (i-i*)+ errort+k
Here,
· ∆St+k is the first difference of nominal exchange rate expressed in terms of domestic currency per unit of foreign currency,
· (i-i*) is the interest rate differentials between the domestic interest rate i and the foreign interest rate i*.
Null hypothesis: α=0 and β =1. The same hypothesis will be used in this study.
Testing of the approximate UIP hypothesis using this specification generally proceeds with a theoretical value of unity for the slope coefficient β in the above regression.
Froot and Thaler (1990) have reported that the average value of β across 75 published studies is−0.88. Numerous other studies have also confirmed that the relationship between the nominal exchange rate changes and interest rate differentials (or forward premium) is negative rather than positive as expected from the hypothesis of UIP.
Objective of the analysis here is to examine the empirical validity of the UIP hypothesis for 3 different countries- India, UK, and Canada. In the analysis US has been considered as the home country. The sample range covers more than 6o data points in term of month, emerging economies in this period witnessed increasing financial liberalization. Here the validity of the UIP hypothesis is tested by using the commonly used form of the UIP equation in a panel estimation of combination of emerging and developed nations.
Further, to study the effect of Consumer Price Index (CPI) and Industrial Production on exchange range, these parameters were factored to the existing UIP equation. This study was carried out considered Canada as the foreign country and US as the domestic country.
[1] Fama, E.F., 1984, ‘Forward and spot exchange rates,’ Journal of Monetary Economics, vol.14 (3) November: 319-38.
[2] McCallum, B.T., 1994b. Monetary policy and the term structure of interest rates. NBER Working Paper
No. 4938
[3] Peter Ankel, Uncovered interest parity, monetary policy and time-varying risk premia, Journal of International Money and Finance, 18 (1999), 835–851
[4] Kenneth Froot and Richard Thaler (1990), Foreign Exchange, Journal of Economic Perspectives, 4(3): 179-92
[5] Lothian and Wu, Uncovered Interest-Rate Parity over the Past Two Centuries, Frank J. Petrilli Center for Research in International Finance CRIF Working Paper series
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