Co-Integrating Currencies and Yield Differentials
Posted: 14 Feb 2006
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: Suggested Citation