Real Yield Variability: A Simple Explanation for the UIRP and Related 'Puzzles' in International Finance

103 Pages Posted: 28 Feb 2014

See all articles by Aris Protopapadakis

Aris Protopapadakis

University of Southern California - Marshall School of Business - Finance and Business Economics Department

Date Written: December 31, 2013

Abstract

I derive a dynamic version of the Dornbusch “overshooting” model in which real yields and inflation vary stochastically, and the exchange rate (FX) delivers UIRP in expectations. Tests using the model provide support for the UIRP proposition. Simulations show that the “disconnect” of FX rates from fundamentals as well as their very high volatility is a necessary consequence of UIRP when real yields are autocorrelated. I also show that FX rates display some predictability as required by the model. Finally, the model shows that the statistical patterns on which “carry trade” is based are consistent with equilibrium.

Keywords: Exchange rates, puzzles, UIRP, real yields, overshooting, predictability, carry trade

JEL Classification: EFF, E47, F31, F41

Suggested Citation

Protopapadakis, Aris, Real Yield Variability: A Simple Explanation for the UIRP and Related 'Puzzles' in International Finance (December 31, 2013). Marshall School of Business Working Paper No. FBE 01.14, Available at SSRN: https://ssrn.com/abstract=2401873 or http://dx.doi.org/10.2139/ssrn.2401873

Aris Protopapadakis (Contact Author)

University of Southern California - Marshall School of Business - Finance and Business Economics Department ( email )

Marshall School of Business
Los Angeles, CA 90089
United States
213-740-6537 (Phone)
213-740-6650 (Fax)

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