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Explaining US–UK Interest Rate Differentials: A Reassessment of the Uncovered Interest Rate Parity in a Bayesian Framework

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  • Andrea Carriero

Abstract

In this paper, we test the uncovered interest rate parity (UIRP), allowing for transitory deviations from it. These deviations may arise from variations in risk premia, errors in expectations and linearization errors, and are modelled as a zero‐mean noise around the restrictions implied by the UIRP on a vector autoregression (VAR) in the interest rate differential and the spot exchange rate. Importantly, this approach includes the traditional one as a special case, which is derived by simply setting the noise to zero. When the noise is set to zero the UIRP is rejected, but if we allow for some degree of noise the UIRP is strongly supported by the data. Thus the UIRP relation does not hold exactly, but on average, with a stationary risk premium as opposed to a constant one. This result implies that analysing the effects of policy experiments under the null of the UIRP may be both safe and useful.

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  • Andrea Carriero, 2006. "Explaining US–UK Interest Rate Differentials: A Reassessment of the Uncovered Interest Rate Parity in a Bayesian Framework," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 68(s1), pages 879-899, December.
    • Handle: RePEc:bla:obuest:v:68:y:2006:i:s1:p:879-899
    DOI: 10.1111/j.1468-0084.2006.00461.x
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    Cited by:

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    2. Joseph P. Byrne & Jun Nagayasu, 2012. "Common Factors Of The Exchange Risk Premium In Emerging European Markets," Bulletin of Economic Research, Wiley Blackwell, vol. 64(Supplemen), pages 71-85, December.
    3. Nandini Srivastava & Stephen Satchell, 2012. "Are There Bubbles in the Art Market? The Detection of Bubbles when Fair Value is Unobservable," Birkbeck Working Papers in Economics and Finance 1209, Birkbeck, Department of Economics, Mathematics & Statistics.
    4. Joseph P. Byrne & Jun Nagayasu, 2008. "Common and idiosyncratic factors of the exchange risk premium in emerging European markets," Working Papers 2008_28, Business School - Economics, University of Glasgow.
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    6. Lorenzo Pozzi & Barbara Sadaba, 2017. "Detecting Scapegoat Effects in the Relationship Between Exchange Rates and Macroeconomic Fundamentals," Staff Working Papers 17-22, Bank of Canada.
    7. repec:spo:wpmain:info:hdl:2441/5221 is not listed on IDEAS
    8. repec:hal:spmain:info:hdl:2441/53r60a8s3kup1vc9kd52ge69h is not listed on IDEAS
    9. repec:spo:wpmain:info:hdl:2441/53r60a8s3kup1vc9kd52ge69h is not listed on IDEAS

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