Uncovered interest parity, monetary policy and time-varying risk premia

Anker, Peter

doi:10.1016/s0261-5606(99)00036-4

Cited by 23 publications

(15 citation statements)

References 18 publications

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“…Does UIP holds because of the specific rule or for some other reason? The result is consistent with McCallum (1994), Anker (1999), and Backus et al (2010) who argue that deviations from UIP are due to the behavior of monetary policy. Indeed, it is possible that by using the exchange rate as a policy instrument a central bank might not only reduce the volatility of CPI inflation, but may also reduce the risk premium associated with the fluctuations in the exchange rate and thus restore the one-to-one link between interest rates and exchange rate dynamics.…”

Section: Exchange Rate Rulesupporting

confidence: 89%

Managing Macroeconomic Fluctuations with Flexible Exchange Rate Targeting

Heipertz

Mihov

Santacreu

2017

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Monetary policy research in small open economies has typically focused on "corner solutions": either the currency rate is fixed by the central bank, or it is left to be determined by market forces. We build an open-economy model with external habits to study the properties of a "new "class of monetary policy rules in which the monetary authority uses the exchange rate as the instrument. Different from a Taylor rule, the monetary authority announces the rate of expected currency appreciation by taking into account inflation and output fluctuations. We find that the exchange rate rule outperforms a standard Taylor rule in terms of welfare, regardless of the policy parameter values. The differences are driven by: (i) the behavior of the nominal exchange rate and interest rates under each rule, and (ii) deviations from UIP due to a time-varying risk premium.

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Section: Exchange Rate Rulesupporting

confidence: 89%

Managing Macroeconomic Fluctuations with Flexible Exchange Rate Targeting

Heipertz

Mihov

Santacreu

2017

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“…Such behaviour implies that the UIP relation, along with a policy response equation for the interest rate differential, is compatible with estimates around -3 for the coefficient of the forward premium in the Fama regression. More recently, Anker (1999) reached similar conclusions in the context of a monetary model for a small open economy in which the central bank reacts to exogenous risk premium shocks. In particular, he showed that interest rate smoothing through the manipulation of exchange rate expectations increases the negative correlation between the risk premium and expected exchange rate changes and, thus, introduces additional downward bias in the forward premium regression coefficient.…”

Section: Introductionsupporting

confidence: 56%

“…Theoretical attempts to reconcile the empirical findings on the predictability of excess returns in foreign exchange markets with central bank interventions (McCallum, 1994;Anker, 1999) have proven largely successful. However, these approaches cannot be tested formally because they are not informative with regard to the time series properties of the underlying variables.…”

Section: Discussionmentioning

confidence: 99%

Discrete policy interventions and rational forecast errors in foreign exchange markets: the uncovered interest parity hypothesis revisited

Kirikos¹

2002

Int. J Fin Econ

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This paper combines policy response explanations of the uncovered interest parity puzzle with a time series approach that accounts for discrete central bank interventions. When monetary authorities manage the interest rate differential through an anti-inflationary policy rule, which allows for discrete shifts, then a stochastic segmented trends representation seems appropriate for the exchange rate and the interest rate differential series. In this setting, rational forecast errors are possible, and a test of the uncovered parity hypothesis, based on the cross-equation restrictions on a Markov switching process, suggests that the parity relationship cannot be rejected for three European currencies vis-" a avis the US dollar. Copyright # 2002 John Wiley & Sons, Ltd.JEL CODE: F31 KEY WORDS: switching regimes; policy rule; markov process; rational forecast errors 1. SUMMARY Empirical rejections of the relationship between expected exchange rate changes and the interest rate differential, also known as the uncovered interest parity (UIP) hypothesis, pose important questions concerning the rationality of economic agents as well as the usefulness of exchange rate structural theories and of many macro-econometric models for which UIP is a building block. Indeed, a rejection of UIP implies that there are systematically predictable excess returns in foreign exchange investments, a result that contradicts rational behaviour.Given that there are no riskless profit opportunities, i.e. the interest rate spread is equal to the forward premium, the validity of UIP implies that the forward premium is the best predictor of future exchange rate changes. Thus, most of the empirical research has relied on linear projections of ex post exchange rate changes on the forward premium and has produced regression coefficients significantly different from one (the value that corresponds to UIP) and more often negative. However, few economists are ready to accept the implications of UIP failure and, therefore, several research directions have been pursued for reconciling the parity relationship with empirical findings.One line of argument suggests that estimates of the above regression slope below 1 2 indicate the presence of a risk premium which is more variable than expected exchange rate changes, but neither static nor general equilibrium models can explain the observed variability of the risk premium. Another approach, based on survey data for exchange rate expectations, attributes the deviation of the regression coefficient from unity to the correlation between the forward premium and forecast errors, an outcome arising from irrational behaviour associated with heterogeneous agents. However, other researchers have argued that

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“…Chinn and Meredith (2004) explain the divergence in short-and long-horizon results by appealing to a monetary reaction function that responds to exchange rate changes. The approach broadly follows the mechanism first suggested by McCallum (1994), and re-interpreted econometrically by Anker (1999) and Kugler (2000). However, Chinn and Meredith explain the pattern of estimates by appealing to a term structure that links short-to long-maturity bonds; since the monetary authority can only directly affect the short rate, and indirectly the long rate, there is less endogeneity of the long-term interest differential.…”

Section: The Long Horizonmentioning

confidence: 99%

The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets

Chinn

2006

Journal of International Money and Finance

222

141

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This paper examines several new empirical findings in the study of uncovered interest parity. It reviews recent developments in the study of long-horizon interest parity regressions, the implications of relaxing the rational expectations methodology and the characteristics of results pertaining to the non-G7 currencies, including those in less developed economies. In brief, the evidence against uncovered interest parity in the current floating rate era is not as great as is commonly thought, although it is still true that for the major currencies, the short-term interest differential remains a biased predictor of ex post changes in the exchange rate.

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Uncovered interest parity, monetary policy and time-varying risk premia

Cited by 23 publications

References 18 publications

Managing Macroeconomic Fluctuations with Flexible Exchange Rate Targeting

Managing Macroeconomic Fluctuations with Flexible Exchange Rate Targeting

Discrete policy interventions and rational forecast errors in foreign exchange markets: the uncovered interest parity hypothesis revisited

The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets

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