Testing the Validity of Uncovered Interest Rate Parity in India



Abstract: One vital potential issue determining the exchange rate is the uncovered interest rate parity (UIP). Uncovered interest parity (UIP) is a typical subject of international finance, a critical building block of most theoretical models, and a miserable empirical failure. Uncovered interest rate parity (UIP) states that the nominal interest rate differential between two countries must be equal to expected change in the exchange rate. In other words, if UIP condition holds, then high yield currencies should be expected to depreciate. The article attempts to test the validity of uncovered interest rate parity based on a theoretical formulation in line with economic theory. Although KPSS test suggest that excess return series are in stationary process, excess return curve shows erratic behaviour during some months of our study period (showing negative trend) which automatically excludes the possibility for the UIP to hold. The UIP regression estimate indicates that there is no statistically significant evidence that suggests the uncovered interest rate parity to hold during January,2006 –July,2010 for  domestic interest rate (weighted average call money rate).This indicates that interest rate spread is a very poor predictor of exchange rate yields. Thus, the UIP hypothesis fails in India.


Keywords: Uncovered interest rate parity, UIP regression, India, excess return, exchange rate, interest rate.

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