Working Paper: NBER ID: w1493
Authors: Takatoshi Ito
Abstract: In this paper, a vector autoregression model (VAR) is proposed in order to test uncovered interest parity (UIP) in the foreign exchange market. Consider a VAR system of the spot exchange rate (yen/dollar), the domestic (US) interest rate and the foreign (Japanese) interest rate, describing the interdependence of the domestic and international financia lmarkets. Uncovered interest parity is stated as a null hypothesis that the current difference between the two interest rates is equal to the difference between the expected future (log of) exchange rate and the (log of) current spot exchange rate. Note that the VAR system will yield the expected future spot exchange rate as a k-step ahead unconditional prediction. Hence, the null hypothesis is stated as nonlinear cross-equational restrictions for the three-equation VAR system. Then UIP is tested by the Wald test between the unrestricted and restricted systems. A test of UIP with a maintained hypothesis of covered interest parity, becomes a hypothesis test of efficiency without risk premium, that is,the forward exchange rate isthe unbiased predictor of the future spot exchange rate, and information is efficiently used in its prediction. Our results are compared to the efficiency test with a single equation using the Hansen-Hodrick procedure for the same data set.
Keywords: Uncovered Interest Parity; Vector Autoregression; Foreign Exchange Market
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| domestic interest rate (rust) (E43) | expected future log exchange rate (F31) |
| foreign interest rate (rjat) (E43) | expected future log exchange rate (F31) |
| expected future log exchange rate (F31) | current spot log exchange rate (st) (F31) |
| domestic interest rate (rust) (E43) | current spot log exchange rate (st) (F31) |
| foreign interest rate (rjat) (E43) | current spot log exchange rate (st) (F31) |
| current difference in interest rates (E43) | expected future log exchange rate - current spot log exchange rate (st) (F31) |