A Panel Data Analysis of Uncovered Interest Parity and Time-Varying Risk Premium

There exist several exchange rate models that associate macroeconomic variables with the exchanges rates. In this article, we focus on uncovered interest parity (UIP) which relates the expected exchange rate changes to the intercountry interest rate differential. We apply various panel econometric methods to test UIP for a wide range of data covering numerous cross currency rates as well as the U.S. Dollar based exchange rates. The results for UIP are mainly unfavorable. We utilize an augmented version of UIP containing time-varying risk premium (proxy: sovereign credit default swap) for a similar analysis to observe whether it makes any improvement. Nevertheless, this version does not get much support too. Although it is common to presume that deviations from UIP are mostly due to a time-varying risk premium, our analysis indicates that this is not true.