Interest Rate Term Premiums and the Failure of the Speculative Efficiency Hypothesis: A Theoretical Investigation

Carol Osler

No 3060, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper develops a new parity condition for international financial markets which relates differences between the forward exchange rate and the expected future exchange rate to interest rate term premiums. It begins with the general proposition that VIP cannot hold for all maturity horizons if interest rate term premiums are imperfectly correlated across countries and expectations are rational. The conditions under which VIP could hold for multiple horizons, under these two assumptions, are found to be very restrictive. It is argued that if VIP holds at all under these circumstances, it is only likely to hold at a very short time horizon. Finally, it is shown that under these assumptions, if VIP holds at the shortest time horizon then the difference between forward exchange rates and expected future spot rates at all other horizons will be the difference in expected term premiums at each maturity.

Date: 1989-08
Note: ITI IFM
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Published as Osler, C. L. "Interest Rate Term Premiums And The Failure Of Uncovered Interest Parity," Journal of International Financial Markets, Institutions and Money, 1992, v2(2), 1-25.

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