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Testing The Uncovered Interest Parity Condition Between The USA and Brazil Large A Model Using MGARCH and Realized Volatilities
Testing The Uncovered Interest Parity Condition Between The USA and Brazil Large A Model Using MGARCH and Realized Volatilities
Testing The Uncovered Interest Parity Condition Between The USA and Brazil Large A Model Using MGARCH and Realized Volatilities
Abstract
This study tests the uncovered interest rate parity between the Brazil-
ian and American markets during the period of June 1986 to August 2016.
The validation of the uncovered parity condition implies efficiency be-
tween markets. The condition is tested through the VECM methodology
proposed in Engle and Granger (1987) utilizing the cointegrating vector
testing the uncovered parity on the long term. The Multivariate GARCH
model proposed by Bollerslev, Engle, and Wooldridge (1988) is used, mod-
eling not only the mean but the variance of the model’s variables, that way
controlling the ARCH (autoregressive conditional heteroscedastic) effect
in financial series. The variances of the variables are estimated through
the Realized Variance estimator, first proposed in Andersen and Boller-
slev (1998), in which the authors show it to be a consistent estimate of the
integrated variance of a given process. The results validate the uncovered
interest parity, showing it to be valid as a long-term equilibrium and that
any deviation is corrected in the long term through the exchange rate
between Brazil and the United States.
1 Introduction
The uncovered interest rate parity (UIP) is an expected relation in the ex-
change rate market that, when valid, shows that investments with equal returns
will yield the same result regardless if the investment is being made in the in-
vestor’s native country or in a foreign country MacDonald (2007). In markets
where the UIP is valid there is no possibility of arbitrage for investors, as such
the UIP is regarded as a inter-market efficiency measure Sarno (2003).
In this article we test the validity of the UIP between the Brazilian and
the American markets. Our model takes in account the period between June
1986 and August 2016. To test the UIP hypothesis we model the USA-Brazil
exchange rate based on it’s time series and the basic interest rate of both coun-
tries. The results of our model will show whether the UIP is corroborated or
not.
To accurately model the phenomena in question we utilize the VEC (Vector
Error Correcting) methodology first presented in Engle and Granger (1987). In
conjunction we utilize a GARCH model as established in Bollerslev (1986) to
better account for stylized facts inherent in financial time series, among those
excess kurtosis and volatility clustering as pointed out in Mandelbrot (1997).
1
Our model also uses realized volatility (RV) estimators proposed in Andersen
and Bollerslev (1998) to get consistent estimations of the integrated variance of
a time series.
Our results show positive results for the validity of the UIP condition. with
the Error Correcting Vector (ECM) showing statistical significance and results
that corroborate the UIP.
On the next section features a brief review of the UIP condition followed by
our econometric model and finally our results and conclusions.
2
3 Data
In the following section we present the relevant data captured to be used
in our empirical model. First, we present the raw data and it’s characteristics,
followed by transformed data that was used in the empirical model.
3
Figure 2: SELIC Interest Rate (% p.m) - Daily
4
Figure 4: Second Difference of Monthly Exchange Rate Returns (DDLEx)
5
3.2.3 First Difference of Federal Fund rate Returns (DLFF)
The first difference of the Federal Fund rate returns was taken to make the
variable stationary. Figure 6 show it’s graph and table 3 shows the ADF test.
6
Figure 7: Error Correcting Model (ECM)
In which, r2 are the quadratic returns, t is the counter for lower frequency
period and i is a counter from 1 to M . where M is the maximum high frequency
observations. In this article, t represents the monthly frequency and i represents
the daily frequency.
On figure 8 we see the graph of the VR ECM.
7
Figure 8: Realized Volatility of ECM (VR ECM)
4 Model
To properly capture the dynamic of this phenomena and empirically validate
the UIP, our empirical model has utilized several different econometric tools. To
capture the volatility clustering effect inherent to financial time series, as evi-
denced in Mandelbrot (1997), we utilize the GARCH methodology put forth in
Bollerslev (1986) due to modeling both the mean and volatility of a time series.
Due to all series being integrated, we also utilize the Vector Error Correcting
Model put forth by Engle and Granger (1987) and impose in the Error Correct-
ing Vector the UIP condition, in which the domestic and foreign interest rates
and the exchange rate have to be equal in the long term.
Due to the multivariate nature of the VECM model, we utilize the MGARCH
model, first used in Bollerslev et al. (1988). Finally, we add the realized volatility
estimator to both the mean and variance equations.
As a result our model is given by the following equations:
yt = Cxt + εt (4)
ht = $ + γV R + α(εt−1 ε0t−1 ) + βht−1 (5)
p
εt = ht zt (6)
8
statistically significant in any equation, we have no evidence for the validity of
UIP condition in these markets.
As the proposed model is a bivariate model, only one cointegrating relation-
ship is possible, therefore it is also expected that the parameter for the variable
ECMt−1 be statistically significant in one one of the equation of the model,
that will point to how the system adjusts itself towards equilibrium, with the
equation with the significant parameter being the one doing the adjustment.
4.1 Results
The following table shows the results of our model.
9
Table 6: Results for Equation DLSELIC
Mean Equation
Variable Coef. St. Error T- Stat P-value
Constant 0 0.000009 -0.498 0.6185
DDLEx 1 -0.0002 0.001718 -0.104 0.9174
DLSELIC 1 -0.283 0.091278 -3.1 0.0021***
DLFF -0.0653 0.12452 -0.524 0.6005
DLFF 1 -0.1114 0.20911 -0.533 0.5946
ECM 1 -0.0017 0.001975 -0.852 0.3948
VR ECM 1 -0.0004 0.000005 -9.587 0.0000***
Variance Equation
Variable Coef. St. Error T- Stat P-value
Uncond. Variance 0.0004 0.00017 2.567 0.0107**
Uncond. Covariance -0.0002 0.000243 -0.725 0.469
b 1 0.7916 0.021741 36.41 0.0000***
a 1 0.611 0.050072 12.2 0.0000***
VR ECM 1 -0.0083 0.002963 -2.805 0.0053***
P-values marked with * are significant at a 10% level, ** at a 5% level, and
*** at a 1%.
WE observe that the parameter of interest for ECM1 shows statistical sig-
nificance in the equation for the DDLEx variable. To assess the quality of
these results we put our model through the standard tests of the Gauss-Markov
assumptions and other tests relevant to our model.
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Table 8: Q Autocorrelation Statistics for DLSELIC
Lags Test Statistics P-Value
Q(5) 7.2685 0.20143
Q(10) 14.1049 0.16826
Q(20) 28.0551 0.1081
Q(50) 51.2632 0.42392
Based on the test statistics, we show that the model has controlled the
autocorrelation effects. em both time series.
Based on the ARCH tests presented, we determined that the model fully
captured the ARCH effect.
11
Table 11: Normality Tests for DDLEx
Test Test Statistic T-Test P-Value
Asymmetry 12.7 98.77 0.0000
Excess Kurtosis 237.62 926.64 0.0000
Jarque-Bera Normality Test 856630 .NaN 0.0000
Based on the test statistics presented, we observe residuals are not normal
in the model.
12
Table 13: Results for Weak Exogeneity Test
Mean Equation
Variable Coef. St. Error T- Stat P-value
Constant -0.00434 0.001746 -2.488 0.0133**
DDLEx 1 -0.20755 0.073949 -2.807 0.0053***
DLSELIC 1 -0.12867 0.10423 -1.234 0.2179
DLFF 0.20976 0.74239 0.283 0.7777
DLFF 1 -0.04456 0.86549 -0.051 0.959
ECM 1 0.48491 0.11179 4.338 0.0000***
VR ECM 1 -0.00033 0.000001 -8.083 0.0000***
Res DLSELIC 1.00712 0.094215 10.69 0.0000***
Variance Equation
Variable Coef. St. Error T- Stat P-value
Uncond. Variance 0.00188 0.001159 1.623 0.1054
b1 0.79281 0.049556 16 0.0000***
a1 0.60946 0.081033 7.521 0.0000***
VR ECM 1 -0.00551 0.004282 -1.286 0.1994
13
Figure 10: Conditional Variances
5 Conclusion
The objective of this article is to empirically test the Uncovered Interest Par-
ity (UIP) condition between the Brazilian and the American market. Finding
evidences of this condition being valid is tantamount to saying there is efficiency
between markets, blocking investors from performing arbitrage.
The empirical literature presents work both proving and disproving the UIP
in different conditions. Works like Juselius and MacDonald (2004), Lily et al.
(2012), Živkov et al. (2016) show that the condition does not hold empirically.
in contrat, works like Marçal et al. (2003), Wagner (2012), NUSAIR (2013) show
the UIP is valid.
In our work, based on the results of our model, we observe that ECMt−1 is
statistically significant in the equation modeling the Real/Dollar exchange rate,
this shows that the long term relationship between the series that form the UIP
14
have a long term equilibrium relationship and that when the relation is outside
of equilibrium the exchange rate corrects to move towards it.
15
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