nr 098 - Uncovering Yield Parity: A new insight into the UIP puzzle through the stationarity of long maturity forward rates

DNB Working Papers
Publicatiedatum 20 april 2006

Results and models of this paper are based on a strikingly new empirical observation: long maturity forward rates between bilateral currency pairs of the US, Germany, UK, and Switzerland are stationary. Based on this result, we suggest a new explanation for the UIP-puzzle maintaining rational expectations and risk neutrality. The model builds on the interaction of foreign exchange and fixed income markets. Ex ante short run and long run UIP and the EHTS is assumed. We show that ex post shocks to the term structure could explain the behavior of the nominal exchange rate including its volatility and the failure of ex post short UIP regressions. We present evidence on ex post validity of long run UIP and strikingly new evidence on the stationarity of the long forward exchange rates of major currencies. We set up, calibrate and simulate a stylized model that well captures the observed properties of spot exchange rates and UIP regressions of major currencies. We define the notion of yield parity and test its empirical performance for monthly series of major currencies with favorable results. JEL Classification: E43, F31 Keywords: EHTS, forward discount bias, stationarity of long maturity forward rates, UIP, yield parity