Uncovering Currency Movements

Making a fortune through Economics' follies

The initial inspiration for this Weblog's title, Uncovered Interests, is a pun on some of the work I have been doing lately; looking at a puzzle in Exchange Rate movements which has occupied an enormous bulk of research in International Economics in the past few decades. The Uncovered Interest-Rate Parity (UIP) Puzzle stems from the striking ability to profit on relative Currency movements with respect to returns on home and foreign investments.

Above, the table shows the 'Fama Regression' (Fama 1984) which under perfect conditions of arbitrage should yield 0 for the first column, Zeta, and 1 for the third column, Beta; the second and forth columns are the range for the respective co-efficients. Under UIP, exchange rate movements, s(t+1)-s(t), between two currencies over time should correspond to the relative home and foreign nominal interest rate differentials, i-i*. The table measures the UIP of the G6 economies against the US over a thirty year period from 1979 to 2009.

Yet in the past forty years of flexible exchange rates for the advanced economies the exact opposite has occured. When British Interest Rates are higher than US Interest Rates, the Sterling has appreciated against the Dollar as opposed to depreciating under UIP. Only Italy comes close in the table above to confirming UIP; but there is a wide gulf between theory and practice.

So it appears then that the UIP puzzle may be related to country-specific idiosyncratic factors; some of the future work requires uncovering, no pun intended, micro-factors. Looking in specific at the behaviour of foreign exchange traders and investors as they react to market fundamentals. Other factors could include finding cohesive unified models for investor risk premiums; and looking at hidden factors such as the positive correlation between short term bonds and interest rates.