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Uncovered Interest Rate Parity

Jim Hamilton Menzie Chinn writes about interest differentials and exchange rate movements:

Econbrowser: Whither the dollar?: What the interest differentials say. One of my long term interests is in the predictability of exchange rates... myself, Yin-Wong Cheung and Antonio Garcia Pascual.... We compared several popular models, including the Dornbusch and Frankel sticky price monetary model, a model based upon productivity differentials, interest rate parity (essentially the forward rate), and a specification incorporating many of these channels -- sometimes called BEERs (for behavioral equilibrium exchange rate models). All of these were compared against a random walk characterization of the exchange rate.

We found that... there was little evidence of outpredicting a random walk, although at long horizons, interest differentials did the best.... [T]he interest parity relationship, even at the long horizon, is not a strong one (the adjusted R-squared from the regression of 5 year changes on 5 year interest rates is 0.05). At the short horizon (one month, 3 months), don't even try using this for G-5 currencies -- the forex traders make plenty of money betting against this relationship (it's called the carry trade).

One last caveat in using interest rates. The past couple of years have seen what some considered aberrant behavior in long term interest rates. Several papers (Chinn and Frankel; Warnock and Warnock) have discussed this. So it may prove even more perilous than usual to rely on long term interest rates to infer dollar movements...

This is one of the most puzzling puzzles in macroeconomics: that foreign-exchange speculators are not very good at linking domestic money and bond markets to the foreign exchange market. Not enough money seems to be engaged in betting that a currencie with a high nominal interest rates will not decline in value fast enough to make investing in its securities unprofitable. Why not? It's an easy thing to do.