The Role of Covered Interest Parity in Explaining the Forward Premium
Anomaly Within a Nonlinear Panel Framework

Dooyeon Cho

PII: S0927-5398(15)00069-9
DOI: doi: 10.1016/j.jempfin.2015.07.002
Reference: EMPFIN 816

To appear in: Journal of Empirical Finance

Received date: 27 December 2014

Revised date: 3 July 2015
Accepted date: 7 July 2015

Please cite this article as: Cho, Dooyeon, The Role of Covered Interest Parity in Ex-
plaining the Forward Premium Anomaly Within a Nonlinear Panel Framework, Journal
of Empirical Finance (2015), doi: 10.1016/j.jempfin.2015.07.002

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 ACCEPTED MANUSCRIPT

The Role of Covered Interest Parity in Explaining the Forward Premium

Anomaly Within a Nonlinear Panel Framework∗

P T
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Dooyeon Cho†

SC
Kookmin University

NU
MA
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Abstract

This paper investigates the dynamic properties of uncovered interest parity (UIP) depending
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on deviations from covered interest parity (CIP) in a nonlinear panel framework. By employing a
panel smooth transition regression model, the threshold level of the CIP deviation in which UIP
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tends to hold is found to be outside the band of inaction where deviations from CIP would fail to
be arbitraged away. This paper shows how reversals of UIP observed during the global financial
crisis can, to some extent, accounted for by funding liquidity constraints. Simulation experiments
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also suggest that the data generating process from the nonlinear panel model can produce data
consistent with the failure of UIP.

JEL Classification: C13; F31; G15

Keywords: Uncovered interest parity; Covered interest arbitrage; Nonlinearity; Time-varying
parameter; Funding liquidity constraints; Band of inaction

∗
The author is very grateful to Richard Baillie, Tae Bong Kim, Joon Park, Dong-Eun Rhee, Seunghwa Rho as well as
two anonymous referees and seminar participants at Sungkyunkwan University and the 2015 Joint Conference of Korean
Economic Societies for their helpful comments and suggestions. All remaining errors are solely the author’s responsibility.
†
Department of Economics, Kookmin University, Seoul 136-702, Republic of Korea; Tel: +82 2 910 5617, Fax: +82 2 910
4519, E-mail: dcho@kookmin.ac.kr.

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 ACCEPTED MANUSCRIPT

The Role of Covered Interest Parity in Explaining the Forward Premium

Anomaly Within a Nonlinear Panel Framework

P T
RI
SC
NU
MA
ED

Abstract

This paper investigates the dynamic properties of uncovered interest parity (UIP) depending
on deviations from covered interest parity (CIP) in a nonlinear panel framework. By employing a
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panel smooth transition regression model, the threshold level of the CIP deviation in which UIP
tends to hold is found to be outside the band of inaction where deviations from CIP would fail to
CE

be arbitraged away. This paper shows how reversals of UIP observed during the global financial
crisis can, to some extent, accounted for by funding liquidity constraints. Simulation experiments
also suggest that the data generating process from the nonlinear panel model can produce data
AC

consistent with the failure of UIP.

JEL Classification: C13; F31; G15

Keywords: Uncovered interest parity; Covered interest arbitrage; Nonlinearity; Time-varying
parameter; Funding liquidity constraints; Band of inaction

1
 ACCEPTED MANUSCRIPT
1 Introduction

There have been many recent analyses of the switching behavior and regime dependence of uncov-
ered interest parity (UIP). The traditional test for the validity of UIP is to estimate the slope coefficient
in a regression of spot returns on the lagged interest rate differential. If UIP holds, the estimated slope
coefficient should yield the value of unity. However, most previous studies have found the slope co-

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efficient estimate to be consistently large and negative, and statistically significantly different from

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unity. This is known as the failure of UIP or the forward premium anomaly.1 This substantial time
variation in the UIP regression has been extensively explored by Bansal (1997), Flood and Rose (2002),

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and Baillie and Cho (2014), among others. In particular, Baillie and Kiliç (2006) show that regime de-

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pendence of UIP can partially be explained by some of the variables generally associated with time
dependent risk premium.
As mentioned in Paya et al. (2010) and Lyons (2001), “the forward bias will not attract speculative

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funds until this trading strategy is expected to generate an excess return per unit of risk exceeding
that of other trading strategies.” As a result, there exists a band of inaction in which the forward bias
persists until the bias is sufficiently large to attract speculative funds. This suggests that deviations
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from covered interest parity (CIP) may offer part of the explanation for the failure of UIP. Taylor (1987,
1989) pointed out that “while there is no evidence of considerable and unexploited profit opportuni-
ties during the normal period, small but profitable arbitrage opportunities occasionally occur during
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the period of turbulence.”

As also explained in Peel and Taylor (2002), deviations from CIP may represent risk-free and prof-
itable arbitrage opportunities, and may, therefore, indicate market inefficiency in the foreign ex-
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change and international capital markets. In other words, under the perfect markets, there should
be no deviations from CIP. However, the presence of various frictions such as transaction costs may
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give rise to a considerable degree of deviations from CIP.2 Thus, there exist risk-free and profitable
arbitrage opportunities for arbitrageurs seeking to profit from any disparity. This can be attributed
to insufficient funding liquidity during the period of turbulence. Investors have relatively limited ac-
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cess to capital, and, thus, there exist limits to risk-free and profitable arbitrage opportunities.3 Peel
and Taylor (2002) investigated covered interest arbitrage using the dollar–sterling exchange rate dur-
ing the interwar period, 1922–1925, and tested the Keynes–Einzig conjecture that deviations from
CIP would not be arbitraged away until they reach ±0.5 percent per annum on an annualized basis.4
Paya et al. (2010) also estimate the exponential smooth transition regression (ESTR) model using the
dollar–sterling exchange rate during the interwar period, 1921–1925, and find that when deviations
from CIP are large, the degree of bias appears to be much smaller than that implied by the standard
forward premium regression.
1
This is also closely related to the carry trade, which denotes the speculative currency investing strategy to invest in
high-interest currencies (or target currencies) by borrowing low-interest currencies (or funding currencies). The carry
trade strategy exploits the empirical failure of UIP.
2
During the period of turbulence, such as the interwar or financial crisis period, deviations from CIP are known to be
substantial.
3
Regarding this issue, Keynes (1923) conjectured that larger deviations from CIP than a half of one percent on an annu-
alized basis would still be moderately persistent because of less-than-perfect elasticity of supply of arbitrage funds.
4
Peel and Taylor (2002) show that an estimated bandwidth of ±0.422 percent using the univariate threshold autore-
gressive (TAR) model is not significantly different from that of ±0.5 percent as conjectured by Keynes (1923) and Einzig
(1937).

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In the standard UIP regression, it is assumed that CIP virtually holds. This paper uses a new
panel smooth transition regression model to investigate the phenomenon with the CIP deviation
or the magnitude of the CIP deviation as a major expository variable. Focusing on the recent crisis
(which according to the U.S. official record, began in December 2007 and ended in June 2009), this
paper finds that the slope parameter estimate yields a positive value greater than the value of unity,
indicating a reversal of UIP. It is also found that the threshold level of CIP in which UIP is valid, lies

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beyond the band of inaction where deviations from CIP would fail to be arbitraged away. The results

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suggest that an obvious reversal of UIP during the recent crisis can be, in part, accounted for by

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funding liquidity risk factors.
The remainder of the paper is organized as follows. Section 2 presents the theory of UIP along with

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the specification of the UIP regressions. Section 3 presents the panel smooth transition regression
model and describes the estimation procedure. Section 4 introduces the data set and presents the
empirical results. Section 5 presents simulation experiments. Section 6 provides concluding remarks.

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2 Uncovered interest parity and covered interest arbitrage
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The theory of UIP refers to the well-documented fact that the expected change in spot exchange rates
is equal to the interest rate differential between two countries. Using the univariate time series, it can
be stated that
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Et (∆st+1 ) = i∗t − it , (1)

where Et (·) denotes the expectations operator conditional on a sigma field of all relevant information
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at time t, st is the logarithm of the spot exchange rate and is measured as the foreign currency price
of one unit of the domestic currency, and it and i∗t are the one-period-to-maturity risk-free domestic
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and foreign interest rates, respectively. It implies that a currency associated with a higher interest
rate tends to depreciate. However, numerous previous studies find that UIP has been empirically
rejected, indicating that a currency associated with a higher interest rate has actually appreciated.
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The theory of UIP postulates the following: i) rational expectations, ii) perfect capital mobility, iii) risk
neutrality among investors, iv) negligible transaction costs, and v) perfect substitutability of domestic
and foreign assets in terms of liquidity, maturity, and default risk. Thus, it implicitly assumes that CIP
virtually holds, so equation (1) can also be expressed as

Et (∆st+1 ) = i∗t − it = ft − st , (2)

where ft is the logarithm of the forward exchange rate for a one-period-ahead transaction. Any dis-
parity on CIP can arise from the presence of different types of frictions. Under a situation where
there exist various kinds of frictions, such as funding liquidity constraints, covered interest arbitrage
opportunities may persist over some period of time, especially during the period of turbulence.5 Fol-
lowing Fama (1984), the test for the theory of UIP has been to estimate the econometric model

∆st+1 = α + β (i∗t − it ) + ǫt+1 , (3)

5
On the contrary, in the normal period, these risk-free and profitable arbitrage opportunities would immediately be
exploited by many arbitrageurs who have access to sufficient funding.

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where ǫt+1 is the error term. Under UIP, the null hypothesis is that α = 0 and β = 1, and the error term,
ǫt+1 , is serially uncorrelated. The failure of UIP refers to the widespread finding of a large and negative
slope coefficient estimate that is significantly different from unity in the estimation of equation (3).
On using panel data, the linear model in equation (3) can be written as

∆si,t+1 = η i + β (i∗t − it ) + εi,t+1 , (4)

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for the subscripts i = 1, ..., N and t = 1, ..., T , where N and T denote the cross-section and time

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dimensions of panel data, respectively,6 η i is the fixed individual effect, and εi,t+1 is the error term.

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Table 2 shows the results from the standard linear UIP regression with country fixed effects using
panel data when the numeraire currency is the US dollar. The slope estimate is negative (−0.458),

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and the null hypothesis of UIP is strongly rejected, as evidenced by the t-statistic of −3.488. It is
not statistically different from zero. The failure of UIP is known to be robust to the choice of the

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numeraire currency.

3 The panel smooth transition regression model

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This section introduces the panel smooth transition regression (PSTR) model with fixed individual
effects developed by González et al. (2005). The model is a generalization of the panel threshold re-
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gression (PTR) model introduced by Hansen (1999), and allows the regression coefficients to change
smoothly and gradually when moving from one group to another. Hence the model allows hetero-
geneity in the regression coefficients, assuming that these coefficients are continuous functions of
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a specific transition variable selected through the transition function, and change between two ex-
treme regimes. The PSTR model with two regimes is given by
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∆si,t+1 = µi + β 1 (i∗it − iU S ∗ US
 
t ) + β 2 (iit − it ) G (zit ; γ, c) + ui,t+1 , (5)
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where µi is the fixed individual effect and the error term ui,t+1 is independent and identically dis-
tributed (i.i.d.). G (·) is the transition function that determines the speed of reversion to UIP. The
transition function is selected to be the logistic function

G (zit ; γ, c) = (1 + exp (−γ (zit − c)))−1 with γ > 0, (6)

where zit is a transition variable, γ is a slope parameter, and c is a location parameter. The restriction
on the parameter (γ > 0) is an identifying restriction. The logistic function in equation (6) is bounded
between 0 and 1, and depends on the transition variable zit for individual i at time t.7 When γ → ∞,
G (·) becomes an indicator function, effectively turning the PSTR model into the two-regime PTR
model introduced by Hansen (1999). Thus, the PSTR model nests a two-regime threshold model.
The values taken by the transition variable zit and the transition parameter γ determine the speed
of reversion to UIP. For any given value of zit , the transition parameter γ determines the slope of the
transition function and, thus, the speed of transition between two extreme regimes.8 The parameter
6
An unbalanced panel is allowed in this study.
7
Thus, G (zit ; γ, c) → 0 as zit → −∞, G (zit ; γ, c) = 0.5 as zit → c, and G (zit ; γ, c) → 1 as zit → +∞.
8
Low values of the slope parameter γ imply slower transitions.

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c can be interpreted as the threshold between two regimes corresponding to G (·) = 0 and G (·) =
1, in the sense that the logistic function changes monotonically from 0 to 1 as zit increases, while
G (c; γ, c) = 0.5. For G (·) = 0 or 1, the PSTR model reduces to a linear panel regression model with
fixed effects. When deviations from CIP are large and positive, or when the magnitude of deviations
from CIP is large, zit will be large and positive, and, thus, G (·) will approach unity. From equation (5),
this corresponds to the upper regime, consistent with UIP, which is given by

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∆si,t+1 = µi + (β 1 + β 2 ) (i∗it − iU S
t ) + ui,t+1 , (7)

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with (β 1 + β 2 ) = 1. In contrast, when deviations from CIP are small and negative, or when the mag-
nitude of deviations from CIP is small and positive, zit will be small, and, thus, G (·) will approach

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zero. This corresponds to the lower regime, which is given by

∆si,t+1 = µi + β 1 (i∗it − iU S

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t ) + ui,t+1 , (8)

where β 1 is consistent with the failure of UIP. Estimating the coefficients in the PSTR model entails
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eliminating the individual effects, µi , in equation (5) by getting rid of individual-specific means. Next,
nonlinear least squares (NLS) estimation is implemented to the transformed data in order to deter-
mine the values of these parameters that minimize the panel sum of squared errors.9 González et
al. (2005) propose a testing procedure to test linearity against the PSTR model and to determine the
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number of extreme regimes. Testing linearity in the PSTR model involves testing H0 : γ = 0. However,
the test is non-standard because under this null hypothesis, the PSTR model contains unidentified
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nuisance parameters (Hansen, 1996). One possible way to avoid this problem is to replace the tran-
sition function by its first-order Taylor expansion around γ = 0 and to test an equivalent hypothesis
in an auxiliary regression. The corresponding test statistic is obtained to see whether linearity can be
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rejected or not. For more details, see González et al. (2005).

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4 Empirical analysis

4.1 Data

This paper uses data on seven freely floating currencies of the Australian dollar (AUD), Canadian dol-
lar (CAD), Swiss franc (CHF), Euro (EUR), British pound (GBP), Japanese yen (JPY), and New Zealand
dollar (NZD). The data are monthly spot and one-month forward exchange rates vis-à-vis the US
dollar (USD) from December 1988 through February 2014. They are collected from Bloomberg and
comprise a total of 303 observations for each currency with the exception of the EUR, which is avail-
able from January 1999 through February 2014. Monthly short-term (money market) interest rates for
eight countries including the United States, are also collected from the International Financial Statis-
tics (IFS) database. The U.S. T-bill rates and LIBOR Eurodollar rates are collected from the St. Louis
Fed’s database, and the VIX which is a measure of the market expectation of stock market volatility
of S&P 500 index options over the upcoming 30-day period, is collected from Chicago Board Options
Exchange (CBOE). Deviations from CIP on an annualized basis in a panel setting, denoted by devit ,
9
It is suggested that sensible starting values can be obtained by performing a two-dimensional grid search over γ and c
in the transition function.

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are calculated as
devit = (fit − sit ) − i∗it − iU S
!

t . (9)

As an alternative measure, the magnitude of deviations from CIP (|devit |) is also considered. Table 1
provides descriptive statistics for panel data. Deviations from CIP and absolute deviations from CIP
are 0.66 and 1.96 percent, respectively, on average over the sample period. The interest rate differ-

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ential appears to be greater than the forward premium, on average, showing 0.71 and 0.05 percent,
respectively. In addition, the standard deviation of the interest rate differential (0.0270) is about 12

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times greater than that of the forward premium (0.0023). As clearly indicated by both average and

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volatility, there have been nonnegligible and sizable deviations between the interest rate differential
and the forward premium over the sample period. Panels (A) and (B) of Figure 1 depict deviations

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from CIP and the magnitude of deviations from CIP, respectively, over time. It can be seen that while
deviations fell in the range of ±0.5 percent per annum during most of the period, there were some

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deviations that exceeded ±1 percent per annum. Notably, the most severe deviation from CIP was
observed over the sample period of 25 years, featuring the minimum value of −4.6 percent per an-
num during the global financial crisis. Furthermore, deviations from CIP were large and persistent
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over some period.

4.2 Estimation results of the panel smooth transition regression model

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Before the PSTR model is estimated, the linear specifications using the two transition variables are
first tested against a specification with threshold effects. In the case where the null hypothesis of
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linearity can be rejected, the PSTR model is estimated with two regimes to capture all the nonlinearity
or, equally, all of the coefficients’ heterogeneity. The results for the linearity tests are reported in Table
3 and are denoted by LMF , and give rise to rejections of the null hypothesis of linearity, with the p-
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values being nearly zero for both cases.

Panels (A) and (B) of Table 3 report the parameter estimates from the PSTR model for the two
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transition variables. The estimated PSTR model involves the presence of two regimes, with the lower
regime that is consistent with the failure of UIP and the upper regime where UIP cannot be rejected.
For the CIP deviation in Panel (A) of Table 3, the slope coefficient estimate corresponding to the upper
regime in equation (7), (β 1 + β 2 ) = −1.157, is negative, and the robust t-statistic of −4.552 indicates
a clear rejection of UIP. Furthermore, the positive slope coefficient estimate corresponding to the
lower regime in equation (8), β 1 = 3.571, is consistent with the failure of UIP. Contrary to this, for the
magnitude of the CIP deviation in Panel (B) of Table 3, the slope coefficient estimate corresponding
to the upper regime, (β 1 + β 2 ) = 2.071, appears to be positive and not far from unity, consistent
with UIP. Furthermore, the robust t-statistic of 1.210 indicates that the slope coefficient estimate
in the upper regime is not statistically different from unity. The negative slope coefficient estimate
corresponding to the lower regime, β 1 = −1.697, is consistent with the failure of UIP, as evidenced by
the robust t-statistic of −5.177. Overall, this suggests that the magnitude of the CIP deviation appears
to be more appropriate in the nonlinear panel framework. Similarly to the findings of Baillie and Cho
(2014), the slope coefficient in the forward premium regression is positive around the time of the
recent financial crisis.
In Table 3, the estimated slope parameter γ is relatively small, which in turn implies that the

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transition function cannot be reduced to the PTR model. As shown in Table 4, the estimated threshold
level of regime switching depending on the CIP deviation is −0.811. For the magnitude of the CIP
deviation, the regime-switching point is 0.587. Interestingly, the two estimated threshold levels of
regime switching in the PSTR model appear to lie beyond the band of inaction, which is ±0.5 percent
according to Keynes (1923) and Einzig (1937).
The primary focus of this paper is on how the parameter estimate of the interest rate differential

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changes over the transition variable and over time in the form of the UIP regression specification.10

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The structural parameters consist of linear and nonlinear parts due to the nonlinearity of the model.

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The time-varying parameter (TVP) obtained from the PSTR model is given by

∂∆si,t+1

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β it = = β 1 + β 2 G (zit ; γ, c) , (10)
∂(i∗it − iU S
t )

where β 1 is the parameter from the linear part of the model, and β 2 is the parameter from the non-

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linear part.11 Based on the estimated PSTR model, Panels (A) and (B) in Figure 2 depict the estimated
TVPs of beta over the two transition variables, respectively. In Panel (A), the estimated TVP of beta
over the CIP deviation are in the range of −1.157 to 3.571. As Table 4 shows, when the CIP deviation
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is −0.640 percent, the estimated TVP of beta is zero. When the CIP deviation is −0.783 percent, the
estimated TVP is the value of unity. As the CIP deviation becomes smaller than −0.783 percent, a re-
versal of UIP takes place; the slope coefficient estimate begins turning into a large and positive value,
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exceeding the value of unity. Similarly, in Panel (B), the estimated TVP of beta over the magnitude
of the CIP deviation change between −1.672 and 2.071. When the magnitude of the CIP deviation
is 0.564 percent, the estimated TVP of beta is zero. Also, when the magnitude is 0.697 percent, the
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coefficient is the value of unity. As the magnitude exceeds 0.697 percent, a reversal of UIP starts to
arise as the slope coefficient estimate becomes greater than one. The threshold levels of −0.783 and
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0.697 percent, at which the estimated TVP of beta turns into the value of unity, appear to be outside
the band of inaction, which is ±0.5 percent according to Keynes (1923) and Einzig (1937).
Panels (A) and (B) in Figure 3 display the estimated TVPs of beta over time. In both Panels (A) and
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(B), the estimated TVPs of beta are found to be negative during most of the sample period. There have
been some time periods in which the coefficients exceeded the value of unity, indicating a reversal of
UIP. Notably, the realizations of some positive values greater than one occurred during the period of
market turbulence.12 In addition, a reversal of UIP was persistent for a few months during the crisis.
This indicates that large deviations from CIP during the crisis may be associated with a reversal of
UIP. As widely explored in previous studies, a common factor that can account for deviations from
CIP and a reversal of UIP during the global financial crisis appears to be funding liquidity constraints.
10
Baillie and Kiliç (2006) use the logistic smooth transition regression (LSTR) model which allows the slope coefficient to
vary over time, to test the theory of UIP with the univariate time series data, using a various set of transition variables.
11
Because the transition function G (zit ; γ, c) is bounded between 0 and 1, it must be the case that β 1 ≤ β it ≤ β 1 + β 2 if
β 2 > 0 or β 1 + β 2 ≤ β it ≤ β 1 if β 2 < 0.
12
For example, some positive values of the estimated TVPs of beta in the early 1990s can be attributed to the European
exchange rate mechanism (ERM) crisis. Also, some positive TVPs of beta exceeding the value of unity in 1999 and 2000 can
be partly associated with the early 2000s recession. The largest positive value for the estimated TVP of beta was observed
during the global financial crisis. As clearly evidenced by Figure 3, the estimated TVP of beta dramatically increased during
the recent crisis, exhibiting the largest estimated TVP beta coefficients of 3.571 in Panel (A) and 2.071 in Panel (B).

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4.3 Relating the estimated time-varying parameters to liquidity risk factors

To account for time variation in the beta coefficient estimates of the UIP regression, this subsection
relates the estimated TVPs of beta to liquidity risk factors. Brunnermeier et al. (2008) explained
that “funding liquidity constraints tend to become particularly important during the financial crisis
period in which global risk or risk aversion increases.”13 This leads to possible redemptions of capital

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by speculators, losses, increased volatility, and increased margins. As in Brunnermeier et al. (2008),
the following two proxies are considered to measure funding liquidity constraints: i) the VIX, which is

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the implied volatility of the S&P 50014 and ii) as an alternative measure, the effect of the TED spread.

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Panels (A) and (B) of Table 5 report the correlations between the estimated TVP of beta and liq-
uidity risk factors. To investigate a dramatic reversal of UIP during the global financial crisis, the

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correlations with and without the inclusion of the crisis period are reported. In Panel (A), in which
the transition variable is the CIP deviation, the correlation between the estimated TVP of beta and

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the VIX is −0.015 with the exclusion of the crisis period. When the crisis period is included, it rises
to 0.306. Likewise, the correlation between the estimated TVP of beta and the TED spread increases
from 0.358 to 0.521 when the crisis period is included. In Panel (B), in which the transition variable is
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the magnitude of the CIP deviation, the correlation between the estimated TVP of beta and the VIX
rises from 0.041 to 0.285 if the crisis period is included. Similarly, the correlation between the esti-
mated TVP of beta and the TED spread increases from 0.373 to 0.520 with the crisis period included.
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In addition, the correlation between the two measures of the VIX and the TED spread also rises from
0.102 to 0.405 with the inclusion of the crisis period. Overall, this suggests that the positive relation
between the estimated TVP of beta and funding liquidity constraints became stronger during the cri-
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sis. This, in turn, indicates that time variation in the beta coefficient estimates of the UIP regression
can be partly explained by the funding liquidity constraints that became more binding for investors
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during the crisis.

As a further step, this subsection explores what portion of time variation in the beta coefficient
estimates of the UIP regression can be accounted for by liquidity risk factors. Panels (A) and (B) of
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Table 6 report the estimation results from regressing the estimated TVP of beta on each liquidity risk
factor. In both cases, the adjusted R2 , which is generally greater for the TED spread than for the VIX,
increases with the inclusion of the crisis. This implies that time variation in the estimated TVP of
beta can be, to some extent, attributed to funding liquidity constraints proxied by the VIX and the
TED spread during the crisis. The estimated coefficient on each liquidity risk factor also increases
when the crisis period is considered, which in turn suggests that the effect of relatively binding liq-
uidity constraints was more prominent during the crisis.15 However, in both Panels (A) and (B), the
estimated coefficient on the VIX is not statistically significant. For the TED spread, the estimated co-
efficient becomes larger, and the explanatory power increases by about twofold from 0.126 to 0.269
in Panel (A) and from 0.137 to 0.270 in Panel (B), with the inclusion of the crisis. In sum, the VIX can
account for time variation in the estimated TVP of beta of about 9.1 and 7.8 percent with the two
13
Higher levels of the VIX or the TED spread give rise to tighter funding liquidity, which successively forces a decrease in
carry trade positions, and thus further reverses the UIP condition.
14
It is worth noting that because the VIX is derived from equity options, it is not mechanically linked to exchange rates,
as emphasized by Brunnermeier et al. (2008).
15
A similar analysis reveals that the recent crisis is different from other crises in the past, for example, time variation in
the estimated TVP of beta cannot be explained by funding liquidity constraints during the ERM crisis.

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transition variables, respectively. Likewise, time variation in the UIP regression can be explained by
the TED spread, with a larger portion of about 27 percent. The results suggest that funding liquidity
constraints appear to account for some portion of time variation in the beta coefficient estimates
during the global financial crisis.16

5 Simulation evidence

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This section provides simulation evidence to see whether the stylized facts of UIP can be obtained

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from the data generating process (DGP) for the estimated PSTR models in equation (5). Consid-
ering possible conditional heteroskedasticity in the exchange rate returns series, it appears to be

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more appropriate to employ the fixed-design wild bootstrap procedure which has been suggested
by Gonçalves and Kilian (2004).17 The procedure is shown to be asymptotically valid for stationary
processes with martingale difference errors subject to possible conditional heteroskedasticity of un-

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known form. Based on the fixed-design wild bootstrap procedure, the pseudo exchange rate return
series {∆s∗i,t+1 }Tt=1 for each currency i is generated using the estimated parameter values reported in
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Table 3 with the DGP,
∆s∗i,t+1 = µ̂i + β̂ it (i∗it − iU S ∗
t ) + ε̂i,t+1 (11)

for the subscripts i = 1, ..., N and t = 1, ..., T , where β̂ it = β̂ 1 + β̂ 2 G (zit ; γ, c), ε̂∗it = ε̂it vit , ε̂it = ∆sit −
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µ̂i − β̂ i,t−1 (i∗i,t−1 − iU S

t−1 ), and vit ∼ N ID (0, 1). The simulated data are generated for 50,000 replications
with 303 observations for each currency, except for the Euro. In each replication, 100 additional
observations are generated and then discarded to avoid initialization effects. For each replication, the
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standard panel linear UIP model (4) is then refitted by regressing the fictitious dependent variable,
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∆s∗i,t+1 on the interest rate differential, (i∗it − iU S
t ) to obtain the simulated slope coefficient of β̂ .
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The results from the simulation experiments are reported in Table 7. In Panel (A), the estimate and
standard error of β obtained from the actual data presented in Table 2 are reported again along with
the 95% confidence interval for the purpose of comparison. In Panel (B), the simulation results over
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the 50,000 replications are reported for the two transition variables employed for the PSTR model.
∗
For each transition variable, the mean of the simulated slope coefficient (β̄ ) is negative, and is close
to the slope coefficient obtained from the actual data. Also, the empirical 95% confidence interval
∗
of the simulated slope coefficient indicates that the mean of the simulated slope coefficient (β̄ ) is
not statistically significantly different from zero as can be seen from the slope coefficient obtained
from the actual data. Thus, simulation experiments using the fixed-design wild bootstrap procedure
suggest that the DGP from the PSTR model is consistent with data that typically lead to the rejection
of UIP or the forward premium anomaly.
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This is consistent with the fact that during the period in which the VIX increases, the carry trade tends to incur losses,
as shown by Brunnermeier et al. (2008). The carry trade strategy exploits the empirical failure of UIP, which yields a large
and negative beta in the UIP regression. On the contrary, a reversal of UIP, which yields a large and positive beta during the
crisis, implies the unprofitability of the carry trade. In other words, the interest rate differential associated with the funding
and target currencies was overwhelmed by the change in spot exchange rates to a greater extent.
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Gonçalves and Kilian (2004) show that the standard residual-based bootstrap procedures treat the regression error as
i.i.d., and these procedures are thus invalid in the presence of conditional heteroskedasticity.

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6 Conclusion

This paper has used the PSTR model with the transition variable being the CIP deviation or the mag-
nitude of the CIP deviation. The empirical findings provide evidence that an obvious reversal of UIP
during the recent crisis can be, to some extent, accounted for by funding liquidity risk factors. Simu-
lation experiments also suggest that the DGP from the PSTR model can produce data consistent with

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the failure of UIP or the forward premium anomaly.

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References

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[1] Baillie, R.T., Cho, D., 2014. Time variation in the standard forward premium regression: some
new models and tests. Journal of Empirical Finance 29, 52–63.

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[2] Baillie, R.T., Kiliç, R., 2006. Do asymmetric and nonlinear adjustments explain the forward pre-
mium anomaly? Journal of International Money and Finance 25, 22–47.

[3] Bansal, R., 1997. An exploration of the forward premium puzzle in currency markets. Review of
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Financial Studies 10, 369–403.

[4] Brunnermeier, M.K., Nagel, S., Pedersen, L.H., 2008. Carry trades and currency crashes. NBER
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Macroeconomics Annual 23, 313–347.

[5] Einzig, P., 1937. The Theory of Forward Exchange. London: Macmillan.
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[6] Fama, E.F., 1984. Forward and spot exchange rates. Journal of Monetary Economics 14, 319–338.

[7] Flood, R.P., Rose, A.K., 2002. Uncovered interest parity in crisis. IMF Staff Papers 49, 252–266.
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[8] Gonçalves, S., Kilian, L., 2004. Bootstrapping autoregressions with conditional heteroskedastic-
ity of unknown form. Journal of Econometrics 123, 89–120.
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[9] González, A., Teräsvirta, T., van Dijk, D., 2005. Panel smooth transition regression models. Work-
ing Paper Series in Economics and Finance 604. Stockholm School of Economics.

[10] Hansen, B.E., 1996. Inference when a nuisance parameter is not identified under the null hy-
pothesis. Econometrica 64, 413–430.

[11] Hansen, B.E., 1999. Threshold effects in non-dynamic panels: estimation, testing, and inference.
Journal of Econometrics 93, 345–368.

[12] Keynes, J.M., 1923. Tract on Monetary Reform. Macmillan, London.

[13] Lyons, R.K., 2001. The microstructure approach to exchange rates. MIT Press, Cambridge.

[14] Mark, N.C., Wu, Y., 1997. Rethinking deviations from uncovered interest rate parity: the role of
covariance risk and noise. Economic Journal 108, 1686–1706.

[15] Paya, I., Peel, D.A., Spiru, A., 2010. The forward premium puzzle in the interwar period and
deviations from covered interest parity. Economics Letters 108, 55–57.

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[16] Peel, D.A., Taylor, M.P., 2002. Covered interest arbitrage in the interwar period and the Keynes–
Einzig conjecture. Journal of Money, Credit and Banking 34, 51–75.

[17] Taylor, M.P., 1987. Covered interest parity: a high-frequency, high-quality data study. Economica
54, 429–438.

[18] Taylor, M.P., 1989. Covered interest arbitrage and market turbulence. Economic Journal 99, 376–

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391.

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TABLE 1. D ESCRIPTIVE STATISTICS

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Change in spot Interest rate Forward Deviation from Magnitude of deviation
exchange rate, differential, premium, CIP, from CIP,
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iU S (fit − sit ) − iit − iU S | (fit − sit ) − iit − iU S |
!
!

∆si,t+1 iit − t fit − sit t t
Mean –0.0006 0.0071 0.0005 –0.0066 0.0196
Std. Dev. 0.0303 0.0270 0.0023 0.0247 0.0165
Maximum 0.1711 0.0971 0.0096 0.0592 0.0893
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Minimum –0.1626 –0.0652 –0.0077 –0.0893 0.0000

Number of Obs. 1993 1993 1993 1993 1993

Note. The sample period is December 1988 through February 2014, with the exception of the Euro,
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which covers the period from January 1999 through February 2014. The interest rate differential, devi-
ation from CIP, and magnitude of deviation from CIP are calculated on an annualized basis.
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TABLE 2. L INEAR UIP REGRESSION USING PANEL DATA

∆si,t+1 = η i +β i∗it − iU S +ε
!

t i,t+1

Parameter estimate
β –0.458
(0.418)
tβ=1 –3.488
Number of obs. 1993

Note. Estimation results with country fixed effects using panel data are
reported. Standard error is in parenthesis below the corresponding co-
efficient. tβ=1 denotes the t-statistic for testing H0 : β = 1.

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TABLE 3. E STIMATION RESULTS FROM THE PSTR MODEL WHEN THE TRANSITION VARIABLE IS
( A ) THE CIP DEVIATION OR ( B ) THE MAGNITUDE OF THE CIP DEVIATION
∆si,t+1 = µi +β 1 i∗it − iU S + β i∗ − iU S
!
 !

t 2 it t G (zit ; γ, c) +ui,t+1 ,
−1
where G (zit ; γ, c) = (1+ exp (−γ (zit −c))) , with zit = dev it or |dev it |.

Parameter estimates

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Transition variable (zit ) ( A ) dev it ( B ) |dev it |

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Linear part
3.571∗∗ –1.697∗∗∗

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β1
(1.482) (0.521)

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Nonlinear part
β2 –4.728∗∗∗ 3.768∗∗∗
(1.588) (1.048)

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Transition parameters
γ 6.563 8.490
(2.371) (5.192)
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c –0.811 0.587
(0.012) (0.009)
Test statistic and p-value for linearity test
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LR 14.026 23.791
(0.000) (0.000)
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tβ 1 +β 2 =1 –4.552 1.210
AIC –7.055 –7.056
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BIC –7.044 –7.045

Number of obs. 1993 1993
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Note. Standard errors adjusted for heteroskedasticity are reported in parentheses

below the corresponding parameters. The likelihood ratio (LR) test result of linear-
ity for each transition variable is reported. H0 : Linear model is tested against H1 :
PSTR model with at least one transition variable. The quantity tβ 1 +β 2 =1 denotes
the robust t-statistic for testing H0 : β 1 +β 2 = 1. ∗ , ∗∗ , ∗∗∗ indicate 10%, 5%, and 1%
statistical significance, respectively.

TABLE 4. T HRESHOLD VALUES FROM THE PSTR MODEL

When the estimated beta coefficient is Regime-switching point

Transition variable Zero Unity where G (·) = 0.5
CIP deviation –0.640 –0.783 –0.811
Magnitude of CIP deviation 0.564 0.679 0.587

Note. The threshold values are given in percent per annum on an annualized basis.

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TABLE 5. C ORRELATIONS OF ESTIMATED TIME - VARYING PARAMETER ( TVP) WITH LIQUIDITY RISK
FACTORS

( A ) E STIMATED TVP WHEN THE TRANSITION VARIABLE IS THE CIP DEVIATION

Entire sample period Excluding the global financial crisis
TVP VIX TED spread TVP VIX TED spread
TVP 1 1

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VIX 0.306 1 –0.015 1

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TED spread 0.521 0.405 1 0.358 0.102 1

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( B ) E STIMATED TVP WHEN THE TRANSITION VARIABLE IS THE MAGNITUDE OF THE CIP DEVIATION
Entire sample period Excluding the global financial crisis

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TVP VIX TED spread TVP VIX TED spread
TVP 1 1
VIX 0.285 1 0.041 1

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TED spread 0.520 0.405 1 0.373 0.102 1

TABLE 6. E STIMATION RESULTS OF ESTIMATED TIME - VARYING PARAMETER ( TVP) BEING REGRESSED
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ON LIQUIDITY RISK FACTORS (LRF )

β̂ t = µ + θ · LRF t +εt
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( A ) E STIMATED TVP WHEN THE TRANSITION VARIABLE IS THE CIP DEVIATION

Parameter estimates
Entire sample period Excluding the global financial crisis
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VIX TED spread VIX TED spread

θ 0.023∗∗∗ 9.234∗∗∗ –0.001 6.301∗∗∗
(0.004) (0.893) (0.004) (1.001)
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Constant –1.289∗∗∗ –1.243∗∗∗ –0.859∗∗∗ –1.129∗∗∗

(0.090) (0.049) (0.080) (0.046)
R̄2 0.091 0.269 –0.004 0.126
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Number of obs. 289 289 270 270

( B ) E STIMATED TVP WHEN THE TRANSITION VARIABLE IS THE MAGNITUDE OF THE CIP DEVIATION
Parameter estimates
Entire sample period Excluding the global financial crisis
VIX TED spread VIX TED spread
θ 0.024∗∗∗ 10.514∗∗∗ 0.004 8.957∗∗∗
(0.005) (1.015) (0.005) (1.354)
Constant –1.562∗∗∗ –1.545∗∗∗ –1.201∗∗∗ –1.489∗∗∗
(0.103) (0.056) (0.109) (0.063)
R̄2 0.078 0.270 –0.002 0.137
Number of obs. 289 289 270 270

Note. Standard errors are in parentheses below the corresponding coeffi-

cients. The time-varying parameter is calculated as the cross-sectional aver-
age of estimated time-varying parameters across the seven currencies in the
sample. R̄2 is an adjusted R2 . ∗ , ∗∗ , ∗∗∗ indicate 10%, 5%, and 1% statistical
significance, respectively.

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TABLE 7. S IMULATION RESULTS FROM THE FIXED - DESIGN WILD BOOTSTRAP

(a) Linear UIP regression results

β̂ –0.458
Standard error of β̂ 0.418
95% confidence interval for β̂ (–1.277, 0.361)

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(b) Simulation results

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When the transition variable When the transition variable is

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is the CIP deviation the magnitude of the CIP deviation
∗
β̄ –0.460 –0.452

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∗
Standard deviation of β̂ 0.595 0.592
∗
95% confidence interval for β̂ (–1.627, 0.707) (–1.613, 0.709)

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Note. The variable β̂ is the actual estimated slope coefficient from the linear UIP regression using panel
∗
data in equation (7). The variable β̄ is the mean of the simulated UIP slope coefficient from 50,000 repli-
cations of the fixed-design wild bootstrap, obtained from estimating the regression (7) using simulated
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data from the estimated PSTR model given in equation (8) as the DGP.
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( A ) D EVIATIONS FROM CIP ( B ) THE MAGNITUDE OF DEVIATIONS FROM CIP

F IGURE 1. D EVIATIONS FROM COVERED INTEREST PARITY (CIP) AND THE MAGNITUDE OF
DEVIATIONS FROM CIP ON AN ANNUALIZED BASIS , RESPECTIVELY. T HE DEVIATION FROM
CIP IS CALCULATED AS THE CROSS - SECTIONAL AVERAGE OF DEVIATIONS FROM CIP ACROSS
THE SEVEN CURRENCIES IN THE SAMPLE . T HE SHADED AREA INDICATES THE GLOBAL FINAN -
CIAL CRISIS OF 2007–2009.

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( A ) T IME - VARYING PARAMETER OVER THE ( B ) T IME - VARYING PARAMETER OVER THE
CIP DEVIATION MAGNITUDE OF THE CIP DEVIATION

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F IGURE 2. E STIMATED TIME - VARYING PARAMETERS OVER THE TRANSITION VARIABLES , THE
PERCENTAGE OF THE CIP DEVIATION AND THE MAGNITUDE OF THE PERCENTAGE OF CIP DE -
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VIATION ON AN ANNUALIZED BASIS , RESPECTIVELY. T HE TVP BETA COEFFICIENT IS CALCU -
LATED AS THE CROSS - SECTIONAL AVERAGE OF ESTIMATED TVP BETA COEFFICIENTS ACROSS
THE SEVEN CURRENCIES IN THE SAMPLE .
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( A ) T IME - VARYING PARAMETER OVER TIME ( B ) T IME - VARYING PARAMETER OVER TIME
WHEN THE TRANSITION VARIABLE IS THE WHEN THE TRANSITION VARIABLE IS THE
CIP DEVIATION MAGNITUDE OF THE CIP DEVIATION

F IGURE 3. E STIMATED TIME - VARYING PARAMETERS OVER TIME . T HE TVP BETA COEFFICIENT
IS CALCULATED AS THE CROSS - SECTIONAL AVERAGE OF ESTIMATED TVP BETA COEFFICIENTS
ACROSS THE SEVEN CURRENCIES IN THE SAMPLE . T HE SHADED AREA INDICATES THE GLOBAL
FINANCIAL CRISIS OF 2007–2009.

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Highlights

· This paper investigates the dynamic properties of UIP depending on
deviations from CIP.

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· The PSTR model is employed to estimate the time-varying parameter in the
UIP regression.

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· The threshold level of the CIP deviation where UIP holds lies outside the band

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of inaction.
· Deviations from CIP were large and persistent during the global financial

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crisis.
· An obvious reversal of UIP during the crisis can be, to some extent,
accounted for by funding liquidity constraints.

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