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Uncovered interest parity: are empirical rejections of it valid?

Uncovered interest parity: are empirical rejections of it valid?
Uncovered interest parity: are empirical rejections of it valid?
There is a vast empirical literature rejecting uncovered interest parity (UIP) on the basis of regressions of the actual exchange rate change against the forward premium/discount. In this paper, whilst we confirm the conventional regression analyses, we argue that they constitute only an indirect test of UIP and that there are serious econometric flaws in such regressions that make them an unreliable means of testing for UIP. Instead, we propose a two new profitability based tests of the UIP condition based on actual dollar returns of being in the domestic and foreign currency and we find evidence that in fact the UIP condition in fact seems to be holding for three of the four parities studied even though the conventional test would have rejected UIP in all four cases. Not only do our economically more meaningful profitability based tests lead us to accept the UIP condition for three of four currencies studied but they also seem to offer superior econometric properties compared to the conventional regression analyses.
efficient market hypothesis, forward discount puzzle, uncovered interest parity
1225-651X
369-384
Olmo, J.
706f68c8-f991-4959-8245-6657a591056e
Pilbeam, K.S.
503cc83a-6194-4f9a-8549-c9a9029563ca
Olmo, J.
706f68c8-f991-4959-8245-6657a591056e
Pilbeam, K.S.
503cc83a-6194-4f9a-8549-c9a9029563ca

Olmo, J. and Pilbeam, K.S. (2009) Uncovered interest parity: are empirical rejections of it valid? Journal of Economic Integration, 24 (2), 369-384. (doi:10.11130/jei.2009.24.2.369).

Record type: Article

Abstract

There is a vast empirical literature rejecting uncovered interest parity (UIP) on the basis of regressions of the actual exchange rate change against the forward premium/discount. In this paper, whilst we confirm the conventional regression analyses, we argue that they constitute only an indirect test of UIP and that there are serious econometric flaws in such regressions that make them an unreliable means of testing for UIP. Instead, we propose a two new profitability based tests of the UIP condition based on actual dollar returns of being in the domestic and foreign currency and we find evidence that in fact the UIP condition in fact seems to be holding for three of the four parities studied even though the conventional test would have rejected UIP in all four cases. Not only do our economically more meaningful profitability based tests lead us to accept the UIP condition for three of four currencies studied but they also seem to offer superior econometric properties compared to the conventional regression analyses.

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More information

e-pub ahead of print date: 1 June 2009
Published date: June 2009
Keywords: efficient market hypothesis, forward discount puzzle, uncovered interest parity
Organisations: Economics

Identifiers

Local EPrints ID: 348568
URI: http://eprints.soton.ac.uk/id/eprint/348568
ISSN: 1225-651X
PURE UUID: a73269ca-7c75-4f90-be99-265c6bc962fc
ORCID for J. Olmo: ORCID iD orcid.org/0000-0002-0437-7812

Catalogue record

Date deposited: 15 Feb 2013 17:00
Last modified: 07 Jul 2020 00:33

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