Uncovered Interest Parity’s Applicability For China And America And Reasons For Its Deviation

As one of the traditional currency pricing theory,Uncovered Interest Parity plays an important role in exchange rate determining theory.Although there is little support empirically for Uncovered Interest Parity during the past thirty years,it still has a profound significance theoretically.Efficient Market Theory is the basis of Uncovered Interest Parity.Empirical studies have given a large number of evidence that Uncovered Interest Parity does not hold.The fact that Uncovered Interest Parity does not hold means that the foreign exchange market is not an effective market.As a result,the topic that Uncovered Interest Parity does not hold has become one of the most important topics in the international financial subject during recent decades.The Uncovered Interest Parity does not apply to most countries,especially for China and America.On July 21,2005 we reformed the exchange rate regime and adopted the managed floating exchange rate system which take a reference to a basket of currencies.Since then,the relationship of exchange rate and interest rate between China and America has experienced the "forward premium puzzle" over a long period,which means that higher the interest rate,more appreciated the currency.The sharp unilateral appreciation of RMB and higher domestic interest rate provided numerous speculation and arbitrage opportunities for international capital.Driven by profit,large number of hot money flew into our country,which in some extent has disrupted the normal operation of foreign exchange market and capital market.At the same time,China is in an economic transition period and the foreign exchange system is not quite perfect.To enhance market efficiency,and to bring the exchange rate of China and America proper pricing mechanism,the paper has empirically researched the reason of Uncovered Interest Parity’s inapplicability between China and America and also pointed out the form of Uncovered Interest Parity’ applicability in China.Firstly,the paper starts with transaction cost to research the reason of Uncovered Interest Parity’s inapplicability between China and America.By testing the applicability of Covered Interest Parity,we find that deviation of Covered Interest Parity has always existed in China.Based on previous studies,and temporarily define the sum of foreign exchange spot transaction cost and forward transaction cost as transaction cost,then we find that deviation of Covered Interest Parity can reflect the 7 effects of transaction cost.Deviation of Covered Interest Parity is defined as a proxy for transaction costs.By researching the relationship between deviation of Covered Interest Parity and deviation of Uncovered Interest Parity,we study the relationship between transaction costs and deviation of the Uncovered Interest Parity.The results show that the proxy variable of transaction costs can largely explain the deviation of Uncovered Interest Parity,indicating that deviation of Uncovered Interest Parity in China can be partly due to transaction costs.Secondly,this paper bases on the exchange rate risk premium and the foreign exchange risk premium to study the reason of Uncovered Interest Parity’s inapplicability between China and America.By establishing a GARCH-M model,we find that the exchange rate risk premium has a significant positive impact on deviation of Uncovered Interest Parity.Then we measure the foreign exchange risk premium of RMB,test the relationship between deviation of Uncovered Interest Parity and RMB’s risk premium,we find that the RMB has an positive systematic risk premium,which can lead to deviation of the Uncovered Interest Parity in a certain extent.The risk premium factor has a significant impact on deviation of Uncovered Interest Parity in China.Next a test on an extended Uncovered Interest Parity model is done,proving that the foreign exchange risk premium and transaction costs do have an impact on deviation of Uncovered Interest Parity.Finally,empirical research is done to prove that the applicability of Uncovered Interest Parity is in the form of cross-border capital flow in China.By analysis of cross-border capital flow in China,establishment of VAR model and Granger Causality Tests,we find that deviation of Uncovered Interest Parity has a close linkage with cross-border capital flow.When there is a significant change in deviation of Uncovered Interest Parity,the profit space will change,causing a change in the direction of cross-border capital flow.The results show that the applicability of Uncovered Interest Parity is in the form of changes of cross-border capital flow,but not changes in interest rates and exchange rates.