Exchange Rates, Uncovered Interest Parity, and Time‐Varying Fama Regressions

Bowen Fu, Mengheng Li and Qazi Haque

Journal of Applied Econometrics, 2025, vol. 40, issue 3, 310-324

Abstract: This paper studies the forward premium puzzle, which signals a violation of the uncovered interest parity (UIP) hypothesis. We test this hypothesis with Fama‐style regressions with time‐varying parameters (TVPs) and stochastic volatility (SV) on six major currencies relative to the US dollar on monthly samples from 1993 to 2018. TVP‐SV regressions are also employed to examine the opposing predictions of the forward premium and excess volatility puzzles often found in exchange rate risk premiums and interest rate differentials. Using Bayesian methods, we document that the riskiness of exchange rates explains the forward premium puzzle, while a liquidity premium reconciles the contrasting predictions of the forward premium and excess volatility puzzles.

Date: 2025
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https://doi.org/10.1002/jae.3111

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Working Paper: Exchange rates, uncovered interest parity, and time-varying Fama regressions (2023)
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