A Reconsideration of the Uncovered Interest Parity Relationship

Bennett T. McCallum

NBER Working Paper No. 4113 (Also Reprint No. r1895)
Issued in July 1992
NBER Program(s):Monetary Economics, International Finance and Macroeconomics

The paper first presents reasons for viewing the uncovered interest-parity (VIP) relationship as more important, in terms of economic analysis, than the unbiasedness of forward rates as predictors of future spot exchange rates. The two hypotheses are closely related, so that test rejections of the latter tend to cast doubt on the former, but are not identical--so unbiasedness rejections are not conclusive for UIP. Next, some representative evidence is presented that pertains to alternative versions of the unbiasedness test. Although s[sub t] = [alpha] + ([beta]f[sub t- 1] + [epsilon, sub t] and s[sub t] - s[sub t-1] =[alpha] + [beta](f[sub t-1] ? s[sub t-1]) + [epsilon, sub t] are equivalent under the null hypothesis of [beta]= 1.0, they represent different classes of alternative hypotheses. Empirically, they give rise to extremely different outcomes, estimates of [beta] being very close to 1. 0 in the former equation but in the vicinity of -3.0 in the latter. In a generalized specification that includes both as special cases, the results strongly favor the second specification--thereby rejecting unbiasedness. Finally, three possible explanations for the [beta] = -3 result are considered and related to the UIP condition. Of these three, the latter two--one involving systematically irrational expectations and the other an additional relationship reflecting monetary policy behavior--are consistent with UIP. The policy-response hypothesis, that monetary authorities manage interest-rate differentials so as to resist rapid changes in exchange rates and in these differentials, is attractive conceptually and is capable of explaining not only the [beta] = -3 finding, but also several other notable features of the data.

download in pdf format
   (1349 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w4113

Published: Journal of Monetary Economics, vol. 33, (1994), pp 105-132 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
Bekaert, Wei, and Xing w8795 Uncovered Interest Rate Parity and the Term Structure
Eaton and Turnovsky w0984 Covered Interest Parity, Uncovered Interest Parity, and Exchange Rate Dynamics
Meredith and Chinn w6797 Long-Horizon Uncovered Interest Rate Parity
McCallum w4938 Monetary Policy and the Term Structure of Interest Rates
NBER Videos

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

Contact Us