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Revisiting Uncovered Interest Rate Parity: Switching Between UIP and the Random Walk

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  • Huisman, R.
  • Mahieu, R.J.

Abstract

In this paper, we examine in which periods uncovered interest rate parity was likely to hold. Empirical research has shown mixed evidence on UIP. The main finding is that it doesn’t hold, although some researchers were not able to reject UIP in periods with large interest differentials or high volatility. In this paper, we introduce a switching regime framework in which we assume that the exchange rate can switch between a UIP regime and a random walk regime. Our empirical results provide evidence that exchange rate movements were consistent with UIP over some periods, but not all. Consistent with the existing literature we also show that in periods with large interest differentials or increased exchange rate volatility, the exchange rate is more likely to follow UIP.

Suggested Citation

  • Huisman, R. & Mahieu, R.J., 2007. "Revisiting Uncovered Interest Rate Parity: Switching Between UIP and the Random Walk," ERIM Report Series Research in Management ERS-2007-001-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.
    • Handle: RePEc:ems:eureri:8288
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    References listed on IDEAS

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    1. Flood, Robert P & Rose, Andrew K, 1996. "Fixes: Of the Forward Discount Puzzle," The Review of Economics and Statistics, MIT Press, vol. 78(4), pages 748-752, November.
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    3. Bilson, John F O, 1981. "The "Speculative Efficiency" Hypothesis," The Journal of Business, University of Chicago Press, vol. 54(3), pages 435-451, July.
    4. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
    5. Martin D. D. Evans & Karen K. Lewis, 2017. "Do Long-Term Swings in the Dollar Affect Estimates of the Risk Premia?," World Scientific Book Chapters, in: Studies in Foreign Exchange Economics, chapter 3, pages 59-99, World Scientific Publishing Co. Pte. Ltd..
    6. Huisman, Ronald & Koedijk, Kees & Kool, Clemens & Nissen, Francois, 1998. "Extreme support for uncovered interest parity," Journal of International Money and Finance, Elsevier, vol. 17(1), pages 211-228, February.
    7. Cheung, Yin-Wong & Erlandsson, Ulf G., 2005. "Exchange Rates and Markov Switching Dynamics," Journal of Business & Economic Statistics, American Statistical Association, vol. 23, pages 314-320, July.
    8. Jeffrey A. Frankel & Giampaolo Galli & Alberto Giovannini, 1996. "The Microstructure of Foreign Exchange Markets," NBER Books, National Bureau of Economic Research, Inc, number fran96-1.
    9. Engel, Charles & Hamilton, James D, 1990. "Long Swings in the Dollar: Are They in the Data and Do Markets Know It?," American Economic Review, American Economic Association, vol. 80(4), pages 689-713, September.
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    11. Chinn, Menzie D., 2006. "The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 7-21, February.
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    Cited by:

    1. Huisman, Ronald & Huurman, Christian & Mahieu, Ronald, 2007. "Hourly electricity prices in day-ahead markets," Energy Economics, Elsevier, vol. 29(2), pages 240-248, March.
    2. Mark David Witte, 2010. "Asian Exchange Rates during the Credit Crisis: Policies to Avoid Depreciation," Global Economic Review, Taylor & Francis Journals, vol. 39(1), pages 15-24.
    3. Huisman, R. & Mahieu, R.J. & Schlichter, F., 2007. "Hedging Exposure to Electricity Price Risk in a Value at Risk Framework," ERIM Report Series Research in Management ERS-2007-013-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.
    4. HOROBET Alexandra Lavinia & DUMITRESCU Sorin-Adrian & DUMITRESCU Dan-Gabriel, 2009. "Exchange Rates And Volatility In Central And Eastern Europe: A Test For Uncovered Interest Parity," Annals of Faculty of Economics, University of Oradea, Faculty of Economics, vol. 3(1), pages 552-557, May.

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    More about this item

    Keywords

    Exchange rate dynamics; Markov regime switching; Uncovered interest rate parity;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • G3 - Financial Economics - - Corporate Finance and Governance
    • M - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics

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