The Uncovered Interest Rate Parity Puzzle in the Foreign Exchange Market

This paper focuses on the theory of uncovered interest rate parity and whether interest-rate differentials have resulted in the higher interest rate currency depreciating over time. Previous literature has empirically rejected the theory indicating that higher interest rate currencies have actually appreciated relative to lower interest rate currencies. In this paper, uncovered interest rate parity is examined from 1992 to 2005 for the Pound sterling-US dollar, Pound sterling-Japanese yen and Pound sterling-Australian dollar currency pairs. A component GARCH model explicitly controls for short-term and long-term volatility and estimates positive slope coefficients, thus supporting the theory of uncovered interest rate parity and a depreciating relationship. This paper also confirms the extreme sampling hypothesis that large interest-rate differentials have a greater effect on currency movements than small differentials. JEL classification: C58; E43; F31; G12