Uncovered interest parity and behavior of interest differentials

Abstract

We analyze the relationship between exchange returns and interest rate differentials through Uncovered Interest Parity (UIP). We use a sample of 83 countries for 1980-2015 period, organizing the information into a panel data structure. The fixed-effects regressions show that the UIP is not fulfilled. However, we observe that the effect of interest rate differential on foreign exchange returns is non-linear. The non-linearity shape suggests that UIP have a lower bias in countries with high interest rate differentials, usually over 38%. Even quartiles regressions show that the positive relationship between exchange rate returns and interest rate differentials would be observed when these variables experience high variations. These results are relevant for monetary and exchange policies design and for investment decisions on exchange markets.