Uncovering uncovered interest parity: exchange rates, yield curves and business cycles

Simon Lloyd and Emile Marin

The textbook uncovered interest parity (UIP) condition states that the expected change in the exchange rate between two countries over time should be equal to the interest rate differential at that horizon. While UIP appears to hold at longer horizons (around 5-10 years), it is regularly rejected at shorter ones (0-4 years). In a recent paper, we argue that interest rates at other maturities — captured in the slope of the yield curve — reflect information about the pricing of ‘business cycle risks’, which can help explain departures from UIP. A country with a relatively steep yield curve slope will tend to experience a depreciation in excess of the UIP benchmark, at business cycle frequencies especially.

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