Co-Integrating Currencies and Yield Differentials

Posted: 14 Feb 2006

Abstract

This study investigates the relationship between currencies and interest rates of different maturity horizons. The real exchange rate is found to depend both on short-term real domestic and foreign interest rate difference and on long-term real domestic and foreign interest rate difference. Co-integrating regressions of contemporaneous currency rates generate negative and significant coefficients for long-term rate differentials, consistent with uncovered interest parity. Therefore, the expectations hypothesis holds for long horizons. On the other hand, positive coefficients for real short-term interest rate differentials reveal the forward premium puzzle: the failure of uncovered interest parity for short-horizons. Results are partly driven by the very different risk characteristics of short-term bonds and foreign bonds.

Keywords: Exchange rates, Interest rates, Uncovered interest parity, Forward premium puzzle

JEL Classification: F31, E43, G14

Suggested Citation

Inci, Ahmet Can, Co-Integrating Currencies and Yield Differentials. Review of Financial Economics, Vol. 15, pp. 159-175, 2006, Available at SSRN: https://ssrn.com/abstract=877218

Ahmet Can Inci (Contact Author)

Bryant University ( email )

1150 Douglas Pike
Smithfield, RI 02917
United States

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