Testing uncovered interest parity under the assumption of liquidity premia

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.