Revisiting Uncovered Interest Rate Parity: Switching Between UIP and the Random Walk

In this paper, we examine in which periods uncovered interest rate parity was likely to hold. Empirical research has shown mixed evidence on UIP. The main finding is that it doesn’t hold, although some researchers were not able to reject UIP in periods with large interest differentials or high volatility. In this paper, we introduce a switching regime framework in which we assume that the exchange rate can switch between a UIP regime and a random walk regime. Our empirical results provide evidence that exchange rate movements were consistent with UIP over some periods, but not all. Consistent with the existing literature we also show that in periods with large interest differentials or increased exchange rate volatility, the exchange rate is more likely to follow UIP.