Working Paper

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;

JEL Classification: F31; F41; G11; G15;

https://doi.org/10.17016/FEDS.2023.074

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2023-11-22

Number: 2023-074