Use of (Time-Domain) Vector Autoregressions to Test Uncovered Interest Parity

Takatoshi Ito

NBER Working Paper No. 1493 (Also Reprint No. r1119)
Issued in November 1984
NBER Program(s):   ME   ITI   IFM

In this paper, a vector autoregression model (VAR) is proposed in order to test uncovered interest parity (UIP) in the foreign exchange market. Consider a VAR system of the spot exchange rate (yen/dollar), the domestic (US) interest rate and the foreign (Japanese) interest rate, describing the interdependence of the domestic and international financia lmarkets. Uncovered interest parity is stated as a null hypothesis that the current difference between the two interest rates is equal to the difference between the expected future (log of) exchange rate and the (log of) current spot exchange rate. Note that the VAR system will yield the expected future spot exchange rate as a k-step ahead unconditional prediction. Hence, the null hypothesis is stated as nonlinear cross-equational restrictions for the three-equation VAR system. Then UIP is tested by the Wald test between the unrestricted and restricted systems. A test of UIP with a maintained hypothesis of covered interest parity, becomes a hypothesis test of efficiency without risk premium, that is,the forward exchange rate isthe unbiased predictor of the future spot exchange rate, and information is efficiently used in its prediction. Our results are compared to the efficiency test with a single equation using the Hansen-Hodrick procedure for the same data set.

download in pdf format
   (276 K)

download in djvu format
   (163 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w1493

Published: The Review of Economics and Statistics, Vol. LXX, No. 2, (May 1988), pp. 29 6-305. citation courtesy of

Users who downloaded this paper also downloaded* these:
Chinn and Meredith w11077 Testing Uncovered Interest Parity at Short and Long Horizons during the Post-Bretton Woods Era
Eaton and Turnovsky w0984 Covered Interest Parity, Uncovered Interest Parity, and Exchange Rate Dynamics
Ito w1187 Capital Controls and Covered Interest Parity
McCallum w4113 A Reconsideration of the Uncovered Interest Parity Relationship
Quah and Ito t0050 Estimation and Hypothesis Testing with Restricted Spectral Density Matrices: An Application to Uncovered Interest Parity
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us