A New Test for Market Efficiency and Uncovered Interest Parity
We suggest a new single-equation test for Uncovered Interest Parity (UIP) based on a dynamic regression approach. The method provides consistent and asymptotically efficient parameter estimates, and is not dependent on assumptions of strict exogeneity. This new approach is asymptotically more efficient than the common approach of using OLS with HAC robust standard errors in the static forward premium regression. The coefficient estimates when spot return changes are regressed on the forward premium are all positive and remarkably stable across currencies. These estimates are considerably larger than those of previous studies, which frequently find negative coefficients. The method also has the advantage of showing dynamic effects of risk premia, or other events that may lead to rejection of UIP or the efficient markets hypothesis.
For helpful comments we thank the co-editor and two referees. All remaining errors are ours alone. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Richard T. Baillie & Francis X. Diebold & George Kapetanios & Kun Ho Kim, 2023. "A new test for market efficiency and uncovered interest parity," Journal of International Money and Finance, vol 130.