Local Deviations from Uncovered Interest Parity: Kernel Smoothing Functions and the Role of Fundamentals15-09-2014
This paper uses recently developed kernel smoothing regression procedures and uniform conﬁdence bounds to investigate the forward premium anomaly. These new statistical methods estimate the local time varying slope coeﬃcient of the regression of spot returns on the lagged interest rate diﬀerential. The uniform conﬁdence bands indicate the extent of the rejections of uncovered interest parity and ﬁnd remarkable variation in both regimes when the anomaly occurs, and also the magnitude of the slope coeﬃcient estimate.
Of particular interest is the fact that the time varying slope parameter can be substantially explained by fundamentals such as monetary growth rates, and also the volatility of US money growth, which is associated with risk premium in many theoretical mdoels. Hence, the apparent deviations from uncovered interest parity have explanations consistent with monetary models and associated risk premium models.