Finance and Economics Discussion Series (FEDS)
November 2023
Uncovered interest rate, overshooting, and predictability reversal puzzles in an emerging economy
Abstract:
By using realized and survey-based expected exchange rate data, the paper presents five key findings regarding the Uncovered Interest rate Parity (UIP) and related puzzles in an Emerging Market (EM). First, Fama regressions, when not accounting for shifts in the UIP relationship, yield slopes that are statistically identical to one, irrespective of whether survey-based expected exchange rates or realized exchange rates are used. Second, caution is necessary however, as our analysis identifies three distinct sub-periods within each exchange rate measure, each exhibiting varying levels of puzzling behavior. Third, under realized exchange rates, expectation errors can introduce both downward and upward biases or no bias at all, depending on the sub-period. On the other hand, currency risk premiums consistently lead to a downward bias. Under expected exchange rates, currency risk premiums continue to exert a downward bias at varying degrees across sub-periods. Fourth, responses to interest rate differential shocks by expectation errors are pivotal in inducing both downward and upward biases or removing biases altogether when utilizing realized exchange rate data. Fifth, evidence concerning overshooting and reversal puzzles, as well as their link to the UIP puzzle, varies depending on the specific sub-period and the choice of exchange rate measurement, making it more intricate than the previous literature has documented.
Keywords: UIP Puzzle, FX Rate Overshooting Puzzle, Predictability Reversal Puzzle, Fama Regression, Expectations
DOI: https://doi.org/10.17016/FEDS.2023.074
PDF: Full Paper
Disclaimer: The economic research that is linked from this page represents the views of the authors and does not indicate concurrence either by other members of the Board's staff or by the Board of Governors. The economic research and their conclusions are often preliminary and are circulated to stimulate discussion and critical comment. The Board values having a staff that conducts research on a wide range of economic topics and that explores a diverse array of perspectives on those topics. The resulting conversations in academia, the economic policy community, and the broader public are important to sharpening our collective thinking.