Testing uncovered interest parity under the assumption of liquidity premia
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Date
2014-05-12
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Abstract
The present study investigates whether liquidity premia can explain deviations
from uncovered interest parity. For that purpose I modify a representative
agent asset-pricing model by assuming that investors value liquidity services
which are unique features of U.S. Treasuries. Further the assumption that
domestic and foreign bonds are perfect substitutes is relaxed. Estimation results for U.S. and U.K. data provide support for the hypothesis that investors
valuation for U.S. Treasuries liquidity contributes to explain deviations from
uncovered interest parity. In contrast to most forward premium regression estimations, I find a positive association between the expected depreciation rate
of the U.S. currency relative to the UK currency and the U.S.-U.K. Treasury
yield spread.
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Keywords
uncovered interest parity, asset pricing, liquidity premium, key currency, exchange rates