Exchange rates, uncovered interest parity, and time-varying Fama regressions

Bowen Fu, Mengheng Li and Qazi Haque

School of Economics and Public Policy Working Papers from University of Adelaide, School of Economics and Public Policy

Abstract: We study the forward-premium and the excess volatility puzzles that violate the uncovered interest rate parity (UIP) hypothesis by estimating the Fama regression with time-varying parameters (TVPs) and stochastic volatility (SV). The forward-premium puzzle predicts a time-varying ex-ante risk premium, and thus motivates the inclusion of TVPs. The excess volatility puzzle predicts excessive volatility of the exchange rate under UIP and motivates the inclusion of SV. These two puzzles make opposing predictions about the risk premium, and the TVP-SV-Fama regression provides a way to examine these conflicting predictions. Estimated using Bayesian methods for six major currencies, we document instability in the UIP relationship, with the forward-premium puzzle disappearing in the post-GFC period. We also find evidence supporting excess volatility and show that both co-movement between the exchange rate and the interest rate differential and SV in the unforecastable component of the exchange rate contribute to the excess volatility.

Keywords: Uncovered interest rate parity; forward-premium puzzle; excess volatility puzzle; Bayesian time-varying regression; stochastic volatility. (search for similar items in EconPapers)
Date: 2023-08
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Persistent link: https://EconPapers.repec.org/RePEc:adl:wpaper:2023-06

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