Discrete Policy Interventions and Rational Forecast Errors in Foreign Exchange Markets: The Uncovered Interest Parity Hypothesis Revisited

Dimitris Kirikos

International Journal of Finance & Economics, 2002, vol. 7, issue 4, 327-38

Abstract: 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-vis the US dollar. Copyright @ 2002 by John Wiley & Sons, Ltd. All rights reserved.

Date: 2002
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