Interest Differentials And Exchange Rate Changes Before And After The Global Crisis

Before 2007M08

and After 2007M09

If the joint hypothesis of uncovered interest rate parity (UIP) and rational expectations –- sometimes termed the unbiasedness hypothesis — held, then the slope of the regression lines (in red) would be indistinguishable from unity. In fact, they are significantly different from that value. This pattern of coefficient reversal holds up for other dollar-based exchange rates, as well as for other currency pairs (with a couple exceptions). The fact that the coefficient is positive in the post-global financial crisis period is what we term “the New Fama puzzle”.

In a NBER working paper released today (No. 24342), coauthored with Matthieu Bussière (Banque de France), Laurent Ferrara (Banque de France), Jonas Heipertz (Paris School of Economics), we re-examine uncovered interest parity – the proposition that anticipated exchange rate changes should offset interest rate differentials.

This is one of the most central concepts in international finance. At the same time, empirical validation of this concept has proven elusive. In fact, the failure of the joint hypothesis of uncovered interest rate parity (UIP) and rational expectations – sometimes termed the unbiasedness hypothesis – is one of the most robust empirical regularities in the literature, vigorously examined since Fama’s (1984) finding that interest rate differentials point in the wrong direction for subsequent ex-post changes in exchange rates.

The most commonplace explanations – such as the existence of an exchange risk premium, which drives a wedge between forward rates and expected future spot rates – have little empirical verification.

Several developments prompt this revisit. First and foremost, the last decade includes a period in which short rates have effectively hit the zero interest rate bound. This point is clearly illustrated in Figure 1 where we plot three-month interest rates for a set of eight selected countries. This development affords us the opportunity to examine whether the Fama puzzle is a general phenomenon or one that is regime-dependent.