The Study Of Uncovered Interest Rate Parity Based On Time-Varying Coefficient Models

The Uncovered Interest Rate Parity (UIP thereafter) puzzle has always been the focus of academic research. This paper extends the traditional form of UIP and studies its validity in both developed countries and emerging countries. Also, we investigate whether some big events led to deviations from UIP.This paper starts from releasing the strict assumptions that investors are risk-neutral, which means we allow investors to be risk averse. In this case, we introduce risk premium into this model and find that the risk premium only exists in Australia and the emerging countries. Then, we estimate the time-varying slope coefficient of the regression of spot returns on the lagged interest differential. The result shows that this coefficient is found to vary substantially over time and UIP holds for some perionds while violates for some other periods. Compared with the tradiontional estimated result, this time-varying model can successfully capture such changing relationship and solve the UIP puzzle.Meanwhile, the result shows that the 1997 Asian Crisi,2008 Subprime mortgage Crisis, the market liberalization reform and America monetary policy changes can impact the UIP relationship in some countries. This means UIP may hold in stable financial environment while may deviate when hit by strong shocks. Since it takes a long time for the deviations to disappear, this explains the reasons why previous study using constant coefficient model always get negative results. In the end, this paper proposes some suggestions to China's financial market reform based on the empirical results.