Revisiting Uncovered Interest Rate Parity: An Empirical Testing Using Bounds Test Approach

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Procedia Economics and Finance 2 ( 2012 ) 45 – 52

2nd Annual International Conference on Accounting and Finance (AF

2012)

Revisiting Uncovered Interest Rate Parity: An Empirical Testing Using

Bounds Test Approach

Jaratin Lily

a,

*, Mori Kogid

a

, Dullah Mulok

a

, Rozilee Asid

a

a_{School of Business and Economics,Universiti Malaysia Sabah, Jalan UMS,88400 Kota KInabalu, Sabah, Malaysia}

Abstract

This study attempts to provide empirical evidence on the Uncovered Interest Rate Parity (UIRP) theory with Malaysia taken as a case study. Though theoretically sound, the UIRP does not seem to hold well empirically. Using quarterly data spanned from the first quarter of 1998 to the third quarter of 2010, the empirical results revealed the violation of the UIRP theory. This indicates that there is a possibility of arbitrage opportunity between Malaysia and the studied markets (Japan, Singapore and United Kingdom) due to the violation of Efficient Market Hypothesis (EMH). The study also found the absence of the forward premium puzzle in any cases.

Selection and/or peer-review under responsibility of Global Science and Technology Forum Pte Ltd

Keywords: UIRP; EMH; bounds test; Malaysia

1. Introduction

Uncovered interest rate parity (UIRP) theory states that the nominal interest rate differential across countries should be an unbiased predictor of future change in the spot exchange rate (Hilde, 2009). The violation of this relationship indicates that capital markets are not efficient and there is a possibility of arbitrage opportunity (see Cook, 2009; Frankel, 1992). Besides, any finding reflecting reverse relationship is called forward premium puzzle (see Bansal and Dahlquist, 2000; Cook, 2009; Inci, 2006). Alper et al. (2007) indicated that emerging markets have weaker macroeconomic fundamentals (e.g. more volatile economic conditions, shallower financial markets, and incomplete institutional reforms) that may contribute to UIRP deviation due to the violation of the efficient market assumptions. Earlier empirical literature on the UIRP

* Corresponding author. Tel.: +6088-320000; fax: +6088-320360.

E-mail address: jaratin@ums.edu.my.

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condition mostly focuses on developed economies rather than emerging markets because of lack of data (Pasricha, 2006). Recently, increases in the degree of financial liberalization in emerging markets enabled many researchers to analyze foreign exchange market efficiency in these economies (Alper et al. 2007) including Malaysia.

The basic assumption underlying UIRP is the efficient market hypothesis (EMH) where the price should fully reflect all the information available to the market participants and thus no profitable opportunities will be possible in the market via speculation (Erdemlioglu and Alper, 2007). Furthermore, it can be considered as a joint hypothesis that the market participants have rational expectations, and that they are risk neutral. UIRP hypothesis has been studied (mainly in the developed markets) through many different currencies, time-periods, interest rate maturity horizons and approaches but there is a mix empirical support for this argument. Majority of the previous studies rejected the UIRP condition empirically (Cuiabano and Divino, 2010; Felmingham and Leong, 2005; Huisman et al., 1998; King, 1998; Pasricha, 2006; Lily et al., 2011). Meanwhile, some study results indicate the forward puzzle where the interest rate differential predicted the expected spot exchange rate change in the wrong direction (Cook, 2009; Craighead et al., 2010; Inci, 2006).

In general, the uncovered interest rate parity condition is k t t t t k t

s

i

s

* or in other form k t t t k t

i

s

* 1 0

where Δst+k is the first difference of nominal exchange rate expressed in terms of domestic currency per unit of

foreign currency (k is the time to maturity), (it - it*) is the nominal interest rate differentials between the

domestic interest rate (i) and the foreign interest rate (i*_{). The combination of the risk neutrality and the}

rational expectations hypothesis is called the risk-neutral efficient markets hypothesis. Testing of the

approximate UIRP condition using this approach generally proceeds with 0

0,

1

in the above

regression. Thus, if the UIRP does not hold in practice, it indicates that one or both of these hypotheses are violated. However, Anker (1999) argued that most empirical evidence of the failure of UIRP is found with this conventional regression. The study results also suggested that interest-rate smoothing was one of the potential reasons for the failure of UIRP condition.

The conventional specification of UIRP hypothesis has been tested extensively using various econometric techniques, but the empirical results have shown mixed explanations. Some of the reasons for these deviations are the existence of time varying risk premiums, market inefficiencies, and neglected persistent autocorrelation in the interest differential and different exchange rate regime (see Anker, 1999, Erdemlioglu and Alper, 2007; Francis et al., 2002; Huisman et al., 1998; Lily et al., 2011). Meanwhile, some of the explanations for the continued use of the hypotheses are because the UIRP deviation depends on the choice in currency pairs and time horizons, as well as, variability and persistence of risk premiums (see Bekaert et al., 2007; Caporale et al., 2001; Chinn, 2006; Drakos, 2003; Inci, 2006; King, 1998; Mehl and Cappiello, 2007).

Mehl and Cappiello (2007) and Inci (2006) found support of UIRP condition when using a long-term interest rate differential whilst Chaboud and Wright (2005) study findings showed that there was also support of the UIRP hypothesis over the short horizon of high-frequency data, though it was not persistent. However, in King (1998) study, the findings showed support for the UIRP in the case of New Zealand-Australia regardless of the choice of the forecast horizon. In addition, Mehl and Cappiello (2007) found support of UIRP for the case of dollar rates in relation to the other major floating currencies (e.g. Canadian dollar, Swiss franc), but not in comparison to emerging market currencies (e.g. Philippines Peso, Malaysian Ringgit).

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Furthermore, Caporale et al. (2001) study on UIRP condition between U.S and foreign currencies, they also found out that UIRP held for the Japanese yen, but not for the German mark.

Since emerging markets deal with inefficient market (existence of additional types of risk premium, high inflation, financial contagion and asymmetric information), there is a possibility to believe that the UIRP hypothesis should not hold in the emerging markets (Alper et al. 2007; Dreger, 2010; Francis et al., 2002). Meanwhile, Chinn (2006) suggested that there was a possibility of UIRP support in emerging markets due to the financial liberalization. However, Francis et al. (2002) pointed out there was contrasting effect of liberalization on UIRP across some Latin American and Asian countries in general. In addition, Goh et al. (2006) found out UIRP deviation between Malaysia and U.S. Moreover, Tang (2011) study results in the case ASEAN 5 and U.S also showed that the UIRP condition was not supported for Indonesia, Malaysia, the Philippines and Thailand cases except for Singapore.

In conclusion, since the creation of the theory, mix explanations still exist in the literature. This disagreement has motivated this research on the UIRP condition in Malaysia by looking into the different types of currency relationships using bounds test approach where the empirical testing has not been developed intensively. Therefore, the purpose of this paper is to examine the UIRP condition in Malaysia using autoregressive distributed lag (ARDL) bounds test approach of Pesaran et al. (2001), which will allow us to overcome the uncertainty about the order of integration of the variables. Contrary to the existing empirical studies in Malaysia that study the UIRP condition, our study looks into the different types of currency relationships using bounds approach where the empirical evidence still has not been developed enormously.

2. Data and Methodology

The data consist of quarterly nominal exchange rates (spot exchange rates, SER) between the Malaysian Ringgit (RM) and three other currencies (Singaporean Dollar or SGD, Yen and Pound,) and nominal interest rates for four countries namely Malaysia, Singapore, Japan and United Kingdom (UK) for the period of 1998:Q1 to 2010:Q3. Singapore, Japan and UK have a significant economic relationship with Malaysia due to their trading activities. The exchange rate and domestic interest rate data have been obtained from the Central Bank of Malaysia monthly bulletin statistical databases. The foreign interest rates were collected from their respective central bank databases. The study used 3-month interbank interest rate (Malaysia, Singapore and UK) and 3-month certificate of deposit (Japan) for interest rate proxy. The data are constructed to be non overlapping quarterly intervals. In addition, the SER for all cases were transformed into logarithm.

Testing the UIRP condition by using the conventional regression model in equation (1) or (2) will lead to model misspecification if there are large changes in both or either exchange rates and/or the interest rates (Tang, 2011). Besides, due to the stationary issue of the change of the exchange rates and the interest rate differentials, using standard OLS analysis may lead to spurious regression. As an example, Goh et al., 2006 found out that the interest rate differential between Malaysian domestic interest rate and U.S interest rate was not stationary at level. Therefore, using ARDL techniques will allow us to consistently test for and estimate the long-run relationship between the interest rate and exchange rate when there is uncertainty if the underlying series are purely I(0), purely I(1), or mutually cointegrated. The study applied the standard Augmented Dickey-Fuller, ADF (Dicker and Fuller, 1981) and Phillips-Perron, PP (Phillips and Perron, 1988) to test for unit root and the order of integration of all the series. The econometric procedures for these unit root tests will be not explained here since they are well documented in the past literature.

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Then, the study employs the Autoregressive Distributed Lag (ARDL) bounds testing approach for cointegration by Pesaran et al. (2001). There are two advantages using this technique. Firstly, the technique can be applied regardless the order of integration of the variables, I(0) or I(1), and secondly, it can be implemented to a small or finite sample size as in the case of this study. The ARDL bounds testing approach are given as follows.

t m i j j i m i i t i t t t

y

x

y

x

y

0 1 1 2 1 1 0

where, 0 is the drift component, and t are white-noise errors. Following Pesaran et al. (2011), two

separate statistics are emloyed to ‘bounds test’ for the existence of a long-run relationship: an F-test for the joint significance of the coefficients of the lagged levels in equation (3) (so that,

H

0

:

1 2

0

), and a

t-test for the null hypothesis

H

0

:

1

0

(see also Banerjee et al., 1998). Two asymptotic critical value bounds

provide a test for cointegration when the independent variables are I(d) (where,

0 d

1

): a lower value assuming, and an upper value assuming purely I(1) regressors. If the test statistics exceed their respective upper critical values, then there is a long-run relationship exists. If the test statistics fall below the lower critical values, then the null hypothesis of no cointegration cannot be rejected. If the statistics fall within their respective bounds, inference would be inconclusive. This technique is considered appropriate and robust for small or finite sample size (see also Narayan, 2004) for sample sizes ranging from 30 to 80 observations). In addition, for long-run relations analysis and to test the UIRP hypothesis in this study, the study considers the general form of conditional ARDL (p, q) model as follows.

q i i t i t p i i t i t

y

x

y

0 2 1 1 0

3. Results Analysis and Conclusion

Fig.1 indicates the UIRP deviation in Malaysia for all cases from the first quarter in 1998 to the third quarter in 2010. The UIRP deviation for all cases is slightly fluctuated except for Malaysia-Japan, which deviates and goes up from the mid of 1998 until the mid of 1999, and then it shows a bit stable deviation at around -0.8 to -0.4. However, it shows that the depreciation rates for Malaysian-Japan case are highly volatile compared to Malaysia-UK and Malaysia-Singapore cases (see Fig. 2).

Fig. 1. UIRP Deviation, 1998Q1 – 2010Q3

-1.0 -0.5 0.0 0.5 1.0 98 99 00 01 02 03 04 05 06 07 08 09 10

Malaysia - UK UIRP Deviation

-2.8 -2.4 -2.0 -1.6 -1.2 -0.8 -0.4 0.0 98 99 00 01 02 03 04 05 06 07 08 09 10

Malaysia - Japan UIRP Deviation

-1.6 -1.2 -0.8 -0.4 0.0 0.4 98 99 00 01 02 03 04 05 06 07 08 09 10

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Fig. 2. Depreciation Rates, 1998Q1 – 2010Q3

Meanwhile, Table 1 shows the descriptive statistic summary for the UIRP deviations. The deviation for Malaysia-Singapore case has the smallest standard deviation which is 0.3064 compared to Malaysia-UK and Malaysia-Japan cases, which are 0.3953 and 0.4543 respectively. The distributions of the UIRP deviations for all cases indicate the rejection of normality assumption based on Jarque-Bera statistics.

Table 1. Descriptive Statistics Summary of UIRP Deviation

Case Scenario Mean Median SD Skewness Kurtosis JB

Malaysia-UK 0.2702 0.3813 0.3953 -1.2621 3.9991 15.3529*** Malaysia-Japan -0.8468 -0.7243 0.4543 -2.8559 10.7153 191.9794*** Malaysia-Singapore -0.3921 -0.3693 0.3064 -1.3133 5.3474 25.8536***

Notes: *** denotes significant at the 1% level. SD = Standard Deviation and JB = Jarque-Bera Statistic.

Table 2 presents the result for unit root tests. It shows that all the variable series (the spot exchange rate and the interest rate differential) for all cases are stationary and integrated at the first difference regardless the inclusion of constant and trend in the test equation or not. Specifically, Malaysia/Japan spot exchange rate is stationary at level using ADF test when only constant included in the test equation. The interest rate differential for Malaysia-Japan is also stationary at level when constant included in the test equation for both ADF and PP tests.

Table 2. Unit Root Tests

Variable

Test Type

ADF PP

Constant Constant & Trend Constant Constant & Trend

SER*_(RM/Pound) _I(1) _I(1) _I(1) _I(1)

SER*_(RM/Yen) _I(0) _I(1) _I(1) _I(1)

SER*_(RM/SGD) _I(1) _I(1) _I(1) _I(1)

IRD (Malaysia-UK) I(1) I(1) I(1) I(1)

IRD (Malaysia-Japan) I(0) I(1) I(0) I(1)

IRD (Malaysia-Singapore) I(1) I(1) I(1) I(1)

Notes: I(0) and I(1) indicates stationary at level and first difference respectively. SER = Spot Exchange Rate and IRD = Interest Rate Differential. *_{denotes transformed into logarithm.} -.20 -.15 -.10 -.05 .00 .05 .10 98 99 00 01 02 03 04 05 06 07 08 09 10 MYR/GBP -.10 -.05 .00 .05 .10 .15 .20 98 99 00 01 02 03 04 05 06 07 08 09 10 MYR/JPY100 -.10 -.08 -.06 -.04 -.02 .00 .02 .04 .06 98 99 00 01 02 03 04 05 06 07 08 09 10 MYR/SGD

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Prior to testing the UIRP hypothesis, the long-run cointegration analysis between spot exchange rate and interest rate differential using ARDL bounds test approach for all cases (see Table 3) was performed. The results show evidence of cointegration relationship for the case of Malaysia-Japan and Malaysia-Singapore indicating the tendency that UIRP might hold in the long-run since both spot exchange rate and interest rate differential tend to move together towards equilibrium.

Table 3. UIRP - ARDL Bounds Test

Case Scenario ARDL(p, q) Wald Statistic, 2

Malaysia-UK ARDL (0, 0) 2.5112

Malaysia-Japan ARDL (5, 0) 18.2681***

Malaysia-Singapore ARDL (0, 1) 5.1231**

Notes: ***, ** denote significant and rejected at the 1% and 5% levels respectively. Figures in ( ) indicates number of lag structures selected based on the lowest SBC. In addition, diagnostic tests were conducted for the purpose of model adequacy. For bounds test, the asymptotic critical value bounds are obtained from Pesaran et al. (2001) and Narayan (2004). The models were estimated using Microfit 4.1.

To validate the precede results from the cointegration analysis, then the study applies the UIRP analysis using long-run regression based ARDL from equation (4). The estimated output can be seen in Table 4. As expected, all the coefficients, ₁, for all cases are positive but highly significant indicating the rejection of UIRP hypothesis. It implies that UIRP generally does not hold in Malaysia using the rational expectations hypothesis.

Table 4. UIRP - Long-Run Regression Based ARDL

Case Scenario Coefficient

Wald Statistic, 2

(Joint Hypothesis,

0: 0 0, 1 1

H )

Malaysia-UK: ARDL(0,1) Based SIC 0 0.0024

1 0.0164

4745.7***

Malaysia-Japan: ARDL(3,0) Based SIC 0 0.1339

1 0.1943

2966.8***

Malaysia-Singapore: ARDL(0,0) Based SIC 0 0.0052

1 0.0201

17036.9***

Notes: *** denotes significant and rejected at the 1% level. The models were estimated using Microfit 4.1.

These findings support the previous findings such as Francis et al. (2002), Goh et al. (2006), Mehl and Cappiello (2007), Alper et al. (2007, Dreger (2010), Lily et al. (2011) and Tang (2011). The UIRP is likely violated in the case of emerging economies like Malaysia because of some reasons such as weaker of financial liberalization and macroeconomics fundamentals as well as exchange rate control. These issues lead to the violation of efficient market in Malaysia. In addition, the study results suggest that nominal interest rate differentials between countries are not the good predictor to the future expected foreign exchange rate in Malaysia.

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Though there is an absence of the forward puzzle in any cases, but the study findings show no support for UIRP conditions in emerging market such as Malaysia indicating the studied markets (Japan, Singapore and Thailand) are still not fully integrated with Malaysian market. This could be a sign of arbitrage opportunities and potential gains that arbitrageur and investor may gain from Malaysia and the studied markets. However, the opportunities and gains become significant if Malaysia has no tight control or restriction in currency or capital movements towards the studied markets. In addition, the expected future foreign exchange rate must not be too volatile, which cause difficulty for forecasting the future exchange rate. Future research should consider on using large span of data, real exchange rate and different type of interest rate maturity to test the validity of the relationship.

Acknowledgements

We would like to thank the editor and anonymous reviewers of this article.

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