A Panel Data Analysis of Uncovered Interest Parity and Time-Varying Risk Premium
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A Panel Data Analysis of Uncovered Interest Parity and Time-Varying Risk Premium Dinçer Afat 1
& Michael
Frömmel 1
Accepted: 6 October 2020/ # Springer Science+Business Media, LLC, part of Springer Nature 2020
Abstract There exist several exchange rate models that associate macroeconomic variables with the exchanges rates. In this article, we focus on uncovered interest parity (UIP) which relates the expected exchange rate changes to the intercountry interest rate differential. We apply various panel econometric methods to test UIP for a wide range of data covering numerous cross currency rates as well as the U.S. Dollar based exchange rates. The results for UIP are mainly unfavorable. We utilize an augmented version of UIP containing time-varying risk premium (proxy: sovereign credit default swap) for a similar analysis to observe whether it makes any improvement. Nevertheless, this version does not get much support too. Although it is common to presume that deviations from UIP are mostly due to a time-varying risk premium, our analysis indicates that this is not true. Keywords Uncovered interest parity . Exchange rate . Panel data . Cross-section
dependence . Panel ARDL . Financial markets JEL Classifications F31 . G15
1 Introduction The economics of exchange rate is the core part of international finance. The related literature puts forward several exchange rate models including uncovered interest parity (UIP) which has been the subject of many empirical analyses. UIP is a straightforward model that associates the expected change in exchange rate with the intercountry interest rate differential. In other words, it is a model to forecast the exchange rate movements by using the interest rate differential. Nevertheless, its
* Dinçer Afat [email protected]
1
Department of Economics, Ghent University, Ghent, Belgium
Afat D., Frömmel M.
applications employ ex-post exchange rate changes and check whether the lagged interest rate differential has been sufficient to predict the exchange rate movements. The common conclusion is that UIP does not work well based on ex-post analyses. Researchers think that time-varying risk premium may be the reason for violation of UIP (see section-2 for detailed explanation and references). In this article, we test UIP by using various panel data methods. Our contribution to the literature is that we work with several horizons and a wide range of data which covers the U.S. Dollar based currency rates as well as some cross currency rates. We also apply an augmented version of UIP (AUIP) that contains time-varying risk premium (proxy: sovereign credit default swap) to check whether it improves the results. We organize the rest of the article as follows; first we discuss the literature and theoretical framework, then we present an empirical analysis and lastly, we state our conclusion.
2 Literature Outcomes In this article, we do not provide a detailed literature survey as there are many comprehensive reviews on UIP such as Engel (2014), Bhatti (2014), Alper et al. (2009) an
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