DP6516 Testing Uncovered Interest Parity: A Continuous-Time Approach

Author(s): Antonio Diez de los Rios, Enrique Sentana
Publication Date: October 2007
Keyword(s): Exchange Rates, Forward Premium Puzzle, Hausman Test, Interest Rates, Orstein-Uhlenbeck Process, Temporal Aggregation
JEL(s): F31, G15
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6516

Nowadays researchers can choose the sampling frequency of exchange rates and interest rates. If the number of observations per contract period is large relative to the sample size, standard GMM asymptotic theory provides unreliable inferences in UIP regression tests. We specify a bivariate continuous-time model for exchange rates and forward premia robust to temporal aggregation, unlike the discrete time models in the literature. We obtain the UIP restrictions on the continuous-time model parameters, which we estimate efficiently, and propose a novel specification test that compares estimators at different frequencies. Our empirical results based on correctly specified models reject UIP.