Testing for uncovered interest parity conditions in a small open economy: A state space modelling approach

Guna Bhatta (), Rabindra Nepal, Charles Harvie and Kankesu Jayanthakumaran

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

Abstract: This is the first study to apply the Kalman filter analysis based on state space modelling to test for the existence of the uncovered interest parity (UIP) condition and simulate the risk premium between the pegged currencies of Nepal and India. We find significant evidence that the UIP condition does not hold in Nepal. Simultaneously, a negative risk premium of about 12 per cent exists on average based on our model calibration using the monthly and the annual time-series data. The Kalman filter simulations further confirm our modelling assumptions that the ordinary least squares-based risk premium estimation is substantially biased in both sign and magnitude. The presence of a negative risk premium provides three key policy implications: a preference to hold foreign assets by residents, the expectation of a future currency devaluation, and obstacles to attracting foreign deposits.

Keywords: uncovered interest parity; State Space Model; Kalman filter; risk premium (search for similar items in EconPapers)
JEL-codes: E43 F33 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2021-07
New Economics Papers: this item is included in nep-mac
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Journal Article: Testing for the uncovered interest parity condition in a small open economy: A state space modelling approach (2022)
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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2021-56

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