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FIN 630
Spring 2016
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Table of Contents
Introduction..................................................................................... 2
Theoretical Development.......................................................................4
Why does the Real Interest Parity condition fail?....................................................7
Econometric Model.............................................................................9
Data............................................................................................ 10
Results and Hypothesis test...................................................................12
OLS...................................................................................................12
Real Interest Parity Convergence...................................................................14
Conclusion.....................................................................................16
Bibliography................................................................................... 18
Appendix I..................................................................................... 19
Appendix II.................................................................................... 21
Appendix III................................................................................... 22
Appendix IV...................................................................................23
Appendix V....................................................................................24
Appendix VI...................................................................................25
Appendix VIII.................................................................................28
1
Introduction
The real interest rate parity is one of the main concerns of international finance. The
Theoretical framework states that real interest rates in domestic country equal real interest rates
in the foreign country (Sirichand, Vivian, and Wohar 72). In this paper, we analyze if the real
interest parity condition holds between the United States and the United Kingdom. For instance,
the condition implies that possible holders of foreign currency deposits view them as equally
desirable assets, given the expected rates of return are the same (Krugman, Obstfeld, and Melitz
83). Consequently, there is no excess of supply nor demand for a particular currency, since the all
The real interest rate parity condition is an important model. The theory is directly
related to exchange rate models. The cross-country equilibrium of real rates has been one of the
main assumptions in the early monetary approach to the exchange rate determination. The real
interest rate differential model states that the real interest parity holds in the long-run when the
exchange rate reaches its long-run equilibrium. Even more, the (real interest rate) RIR
differential partially explains the exchange rate movements. (Wu and Chen 838)
Further, the real interest rate parity is a concern to policy makers. If the interest rate
parity equality is true or even hold under certain conditions, then domestic monetary
authorities have no control over their real rate relative to the world rate, limiting the impact of
their stabilization policies. In fact, unless real rates can differ across countries, policies at
increasing domestic savings cannot increase the rate of capital formation and hence
Over the past 3 decades, the global financial integration has been increasing nonstop.
Under those circumstances, the international financial markets and the national financial market
2
have been emerging. In theory, if both international and national market become a one-world
market, every country real interest rates should display a long-run convergence trend; in other
words, the real interest rate should exhibit uniformity in the long-run. Such a complete
convergence is known as the RIP (real interest parity) hypothesis. (Singh and Banerjee 3).
The main objective of this paper is to analyze the RIP condition. For the purpose, we
analyze the US and UK real interest rates, period 1980Q1 to 2015Q4. We want to observe if the
RIP equilibrium exists between those two countries in the short-run. Also, we observe if there is
any long-run convergence of the real interest rates between countries. The convergence is a more
relax way to analyze the RIP condition. As it implies a tendency to equilibrium. Even more, the
convergence of real interest rates can be view as a measurement of financial integration between
With this in mind, we investigate the RIP by examining the stationarity of the real
interest differentials with unit-root tests. With the unit-root tests, we can observe whether real
interest differentials are mean reverting in the long run, which implies that the interest parity is
supported in the long run (Wu and Chen 838). Further, we regress US real interest rate vs UK
real interest rate, to address only the static behavior of the short-term real rate differential (Singh
and Banerjee 3). However, we apply the cointegration test to hypothesize about the long-run
relationship. Overall, the level of significance applied to the hypothesis tests will be 5%.
Even though, the theoretical framework of the RIP might appear rigorous and
impeccable. The equalization of real interest rates across countries may not be obtained under
systems of flexible exchange rates, due to high exchange rates variability and foreign exchange
risk premium, and the lack of power in the standard unit root tests (Nusair 426). However, we
expect our data to support the theory for the particular case between US and UK.
3
Theoretical Development
For instance, the real interest parity (RIP) states that the expected domestic real rate is
equal to the expected foreign real interest rate (Sirichand, Vivian, and Wohar 72-73). In
particular, the theoretical arguments that lead to the RIP conditions follow from the following
R$ ,t R ,t = Eet +1 (1)
r e ,t =R ,t eUk ,t +1 (3)
r e$ ,t =R$ , t US
e
, t +1 (4)
Where:
et+ 1 = is the logarithm of the expected price level (inflation) at time t+1.
e
r t = is ex-ante real interest rate at time t.
The equation (1) is the uncovered interest parity, it states that the expected change in the
exchange rate (US dollar and sterling pound exchange rate) over a period of time should be equal
to the interest rate differential (US dollar nominal interest rate minus UK nominal interest rate)
over the same period (Nusair 429). Further, it implies that foreign exchange market is in
equilibrium when deposits of all currencies offer the same expected rate of return; currency
deposits are equally desirable between UK and US. (Krugman, Obstfeld, and Melitz 83)
Secondly, the equation (2) is ex-ante relative purchasing power parity (PPP), which
states that the expected change in the exchange rate between two countries over any period
4
equals to expected inflation differential (US expected inflation minus UK expected inflation)
over the same period (Nusair 429). The relative PPP asserts that prices and exchange rate change
in a way that preserves the ratio of each currencys domestic and foreign purchasing powers
Thirdly, equation (3) is the US ex-ante fisher equation, which states that ex-ante real
interest rate is equal to the nominal interest rate minus the expected inflation, and equation (4) is
ex-ante UK Fisher equation (Nusair 429). The fisher equation provides the link between nominal
Further, the ex-ante RIP (the expected RIP), it is derived by combining equations (1) and
(2) yields.
e e
r $ ,t =r , t (5.2)
If the four parity conditions hold (equations 1-4), then ex-ante real interest rates must
equalize across countries (Nusair 429). However, equation (5) is not testable since the ex-ante
inflation is an expected variable. Put in other words, they are not observable in the current period
since they are expectations. Consequently, a proxy for expected inflation must be utilized. (429)
measurement assumptions. Although one does not observe the expected inflation rate it can be
approximated by three general approaches, the first approach uses the unbiased hypothesis where
we calculate ex-post real interest differential. The second approach assumes rational
expectations. The third approach is to model inflationary expectation as a time series process.
(5)
5
Accordingly, in this paper, we calculate ex-post real interest differential as a proxy to the
ex-ante real interest differential. In order, to simplify the analysis. However, results might be
Overall, the fisher effect defines the long-run relationship between ongoing inflation and
interest rates. If assume all else constant, a rise in a countrys expected inflation rate will
eventually cause an equal rise in the interest rate that deposits of its currency offer. Similarly, a
fall in the expected inflation rate will eventually cause a fall in the interest rate. (Krugman,
6
Why does the Real Interest Parity condition fail?
The theoretical relevance of the real rate equality is unquestionable. Yet, the empirical
supports for the parity condition diverges from one study to another. A significant amount of the
studies concludes that real interest parity condition is weakly supported. The failure to support
the real interest parity for developed countries presents a puzzle: Why does the real interest
parity fail, given the current system of a highly integrated capital market? (Wu and Chen 838)
financial integration may not lead to the equalization of real interest rates across countries under
a system of floating exchange rate due to high exchange rate volatility and the foreign exchange
risk premium (431). Similarly, Sirichand, Vivian, and Wohar; find that convergence toward RIP
is much weaker during the managed float period compared to the Gold Standard period (78).
Further, Chung and Crowder, concludes that Fisher relation has a wide support
empirically but that uncovered interest rate and ex-ante relative purchasing power parity is not
widely supported. Overall, it is implied that if two of the parity conditions do not hold. As a
result, the real interest parity condition does not hold. The rejection of the uncovered interest rate
is consistent in most of the literature that finds a significant risk premium in foreign exchange
markets. (456-457)
With regard to the PPP, the support is weak in recent data, the failure is related to trade
barriers and departures from free competition. Additionally, different measurements of price
level by country governments may contribute to the empirical failure. The Consumer price index
takes into account a specific bundle of goods, subject to countries specific consumption patterns
7
Regardless, other papers, even recent ones, support the RIP condition. For instance, Shi,
Li, and Alexiadis; their research paper concludes that the real interest rated are mean reverting
and the RIP hypothesis holds in the must of the G6 (Canada, France, Japan, Italy, Singapore, UK
and the US) countries. In particular, their paper applies the KPSS and DF-GLS to test stationarity
in the real interest rate differential among the countries. A stationary process has the following
features: mean, variance and autocorrelation do not change over time. If RID is stationary of
mean zero, it implies that real interest rates are equal over time, among countries. (465)
Even more, the uncovered interest rate parity is supported in Asian economies and
emerging markets (Sirichand, Vivian, and Wohar 74). However, the condition might not hold
between an eastern and western country. Since interest rates are not measured in comparable
terms. The measurement is subject to countries central banks decisions. Consequently, the
interest rate between countries can move differently over time (Krugman, Obstfeld, and Melitz
79).
form of RIP. It consists in analyzing the tendency towards parity. Sirichand, Vivian, and Wohar;
states the following: First, we find that there is adjustment towards RIP in the long run. Second,
and importantly, we find that this is driven by reversion in inflation differentials and no by
reversion in nominal interest rates. The results have an important implication from the policy
making point of view. It implies that nominal interest rates converge slowly. Therefore, it
suggests that central banks can carry out its monetary policy to some degree independently. (82)
8
Econometric Model
The condition of real interest parity follows: (Shi, Li, and Alexiadis 174)
r UK , t= ^ + ^ r US ,t +
where r UK , t is the real interest of United Kingdom, r US ,t is the real interest of the US. In the
model above, ^ is the estimated intercept and ^ is the estimated slope. We expect the
estimated intercept to be zero and the estimated slope to be 1, the hypothesis implies that
Further, if the I (0) , the US and UK interest rate have a cointegrating relationship.
Consequently, it can be stated that the RIP will converge in the future. In other words, in the
long-run, both UK and US real interest rates tends to uniformity or same value.
H0) ^ r US ,t =1 =0
H1) ^ r US ,t 1 0
Additionally, in order to test the RIP convergence, the model is specified as: (Shi, Li, and
Alexiadis 171)
ridt = 0 + 1 ridt 1 +
Where ridt the real interest differential between US and UK. If rid is mean
reverting in the long run, the RIP hypothesis holds in the long-run equilibrium. In other words, if
1=0 , the rid is stationary and the real interest rate of both countries converges. For the
purpose of, we use Augmented Dickey-Fuller-GLS (ADF-GLS) test, Phillips-Perron test, and the
9
The convergence testing relies on the validity of the unit root tests. The standard unit
root test (Dickey-Fuller) is weak when the autoregressive root is close to but still less than unity
(Chung and Crowder 445). Consequently, the issue is addressed by using the ADF-GLS unit root
test, the KPSS stationarity test, and Phillips-Perron test. These tests, are more powerful than the
standard dickey fuller (Nusair 428). And may be complementary to each other.
Data
In particular, for this paper, the data utilize involve two countries: The United Kingdom
and the United States. In the model, US is the benchmark, we regress UK real interest rate vs US
real interest rate. The sample data includes quarterly observations on the Consumer Prices Index
(CPI), and the interest rate. The data was collected from the International Monetary Funds
International Financial Statistics (IFS). The sample covers period 1980Q1-2015Q4. In Particular,
the selected period is an aftermath of the collapse of the Bretton Woods system in 1973 and the
increase in the degree of international financial integration, as a result, to the reduction of many
capital controls in the 1970s and 1980s (Nusair 451). Thus, we may avoid structural changes in
the relationship between the regressand and the regressor by choosing a period with a constant
exchange rate system. In other words, we want the values of the parameters of the model to
remain constant through the entire period of time. However, structural changes may also be due
The interest rates utilize for both US and UK is the 3-month treasury bill rate (per
annum). An alternative to the 3-month treasury bill rate could be the 3-month deposit rate. In
regards to the choice of maturity, as stated by the liquidity premium theory in which investors
tend to prefer bonds with short-term maturities rather than bonds with longer-term maturities
since they tend to bear less interest-rate-risk. (Shi, Li, and Alexiadis 173)
10
Similarly, to Shi, Li, and Alexiadis, three steps are utilized to obtain the real interest rate
and the real interest rate differential. First, the inflation rate must be calculated using the
Consumer Price Index (CPI). The following equation is use for the purpose: (174)
Further, it must be taken into account that even though UK and US have a similar base
year for the CPI calculation, the definitions of price levels may differ. Since government
measures of the price level differ from one country to another country. Since individuals living in
different countries spend their incomes in different ways. (Krugman, Obstfeld, and Melitz 149)
Second, the nominal interest rate must be converted to the real interest rate. The Fisher equation,
nominal interest rate minus the expected interest rate, is use for the purpose:
r t =Rt et+ k ,
where r t is the real interest rate in spot t, period k; and et+ k is expected inflation from spot
t to spot take. However, for the estimation, the ex-ante inflation is used as a proxy for the post-
The main distinction between nominal interest rate and real interest rate. Nominal interest
rates, are rates of return measure is monetary terms, and real interest rates, are rates of return
Third, to obtain the real interest differential (RIP) the following equation is use:
RID t=r , t r $ , t ,
where RIDt is the real interest rate differential against the US at spot t (174). Furthermore, the
11
Results and Hypothesis test
OLS
For a start the estimated model utilizing Ordinary least square is the following:
r^ UK , t=1.579102+(1.038615)r US ,t
i
^
se
t=( 5.67 ) (18.91)
Rsquare=0.7157 n=144
where the estimated intercept is 1.579102 and the estimated slope is 1.038615 . We
expected the estimated intercept to be zero and the estimated slope to be 1, the hypothesis
implies that real interest parity condition between UK and US holds. Yet, both the estimated
intercept and the slope are statically significant at a confidence level of 95%. (Appendix II)
However, these initial results are not reliable. According to the Skewness/Kurtosis test
for normality in the residual, the probability for both skewness and kurtosis is 12.11% and
6.11. Consequently, there is no enough evidence to said the residuals are normally distributed.
Thus, the confidence intervals of the initial estimations are not reliable. (Appendix III)
Further, the residuals are positively correlated. According to the BreuschGodfrey test,
the residuals are correlated for the first 5 observations. Being that, the hypothesis test initially
apply is not reliable. In view of, the estimators are unreliable. (Appendix III)
In order to address the issue. We re-estimated the model utilizing the Newey-West
Standard errors with a maximum of 5 lags. Accordingly, to what the BreuschGodfrey test
suggests. The estimated model utilizing the new method is the following:
r^ UK , t=1.579102+(1.038615)r US ,t
12
i
^
se
t=( 3.21 ) (8.90)
Rsquare=0.7157 n=144
For instance, it can be observed that both estimated slope and intercept remain the same
since the model only addresses the standard errors. However, the estimated parameters remain
hypothesize. But, the intercept in contrast to our expectations is statically different from zero.
Then, it can be said that for the given sample the Real Interest Parity condition does not hold in
Furthermore, the cointegration test suggests that for the given sample the Real Interest
Parity condition may hold in long-run. According to the DF-GLS test on the residuals for 13 lags,
the null hypothesis of a unit root is rejected for lags 2, 4, 5, and 6, at a 1% critical value.
Additionally, it is rejected in many of the lags at 5% and 10% critical value. According to the
test, the lags 1, 2, 4, 5, 6, 12 and 13 are stationary at 5% critical value; and the lags 1, 2, 3, 4, 5,
6, 8-13 are stationary at 10% critical value. Therefore, the long-run relationship between the US
and UK real interest rates is partially supported for the given sample. If the residuals are
nonstationary (the unit root hypothesis is accepted), and it is also implied that both real interest
rate, the US, and the UK, have a spurious relationship. The long-run relationship is further
Further, what the estimated model reveals is that the UK real interest rate return is greater
than the US real interest rate return. The model suggests that for every unit change in the US real
interest rate a proportional change of 1.04% is observe in the estimated UK real interest rate.
13
Additionally, the intercept suggests that when the US RIR is zero the estimated UK RIR is
1.58%.
The estimated model displays that the UK RIR has a more desirable rate of return
relative to the US RIR return. Even more, the R-square indicates that the model explains the UK
In order to test the convergence of real interest parity condition in the long-run, three
methods are utilized in this paper; DF-GLS, KPSS, and Phillips-Perron unit root test. If real
interest rate differential is mean reverting in the long run, the RIP hypothesis holds in the long-
run equilibrium. Otherwise, the hypothesis is rejected for the given sample. That being the case,
the following unit root tests are applied directly to the real interest rate differential between UK
and US:
1. DF-GLS Test
The results indicate that the real interest rate differential between UK and US is
stationary at a 1% critical value for lags 4, and 5 out of 13 lags. Conversely, if the critical
value is increase to 5% and 10%, the null hypothesis of unit root test is rejected for many
and 13.
Notably, the results are similar as the indicated by the cointegration test. The RIP
convergence is partially supported. Though, the DF-GLS along with the KPSS are tested
intending to deal with the flaws of the Augmented-Dickey-Fuller and Phillips-Perron test.
Yet, there is not such and advance unit root test which is easy and convenience to
14
2. KPSS test
On the other hand, the results of the KPSS stationarity test are subject to the number of
lags utilize. The KPSS test with 12 lags indicates stationarity, but when 2 lags are used it
indicates unit root. In the first, it is indicated that the RID are mean reverting in the long-
run, and thus, the parity condition does hold in the long-run. However, as with the
standard unit root tests (ADF and PP), there is potentiality for size and power problems.
That being the case, we used it as a complementary to the examination of the unit root
and not as a conclusive test. This test differs from those commonly used, its null
hypothesis is stationarity. The test may be conducted under the null of either, trend
stationarity (the default) or level stationarity. Accordingly, the estimated eta/s are
hypothesis of a stationarity at all common significance levels. The results are the same
Overall, the stationarity tests applied, partially supports the real interest parity condition
in the long run for the given sample. According to the KPSS with 12 lags and PP tests, the results
indicate that the real interest rate differential between UK and US is stationary at a 5%
significance level. Equally, in the DF-GLS test, the hypothesis of unit root is rejected for many
of the lags at the 5% critical value. While, the KPSS with 2 lags rejects the stationarity
hypothesis. Yet, both KPSS and PP tests are used as a complement for the DF-GLS.
The advantage of the DF-GLS can be summarized as follows: The time series is
transformed via a generalized least square before performing the test. And the test is performed
analogously but on GLL-detrended data. Overall, it has more statistical power than the standard
15
Conclusion
The theoretical framework of the interest real interest parity condition states that real
interest rates in domestic country equal real interest rates in the foreign country. Otherwise, there
will exist and excess of demand for the currency with greater return. In other words, the assets
are not equally desired across countries. The estimated model utilizing sample data period for
1980Q1-2015Q4, for US and UK real interest rate, indicates that UK real interest rate of return is
greater than the US. Consequently, the interest parity condition does not hold in the short-run.
Also, the interest parity condition in the long-run is weakly supported by the DF-GLS unit root
For the real interest rate parity equality hold four other parity conditions must hold:
be equal to the interest rate differential over the same period. Further, it implies that
foreign exchange market is in equilibrium when deposits of all currencies offer the same
any period equals to expected inflation differential over the same period.
The US and The UK ex-ante fisher
which states that ex-ante real interest rate is equal to the nominal interest rate minus the
expected inflation. The fisher equation provides the link between nominal and real
interest rates.
Furthermore, it is probable that the PPP and the uncovered interest parity are the parity
conditions that do not allow the RIP to hold in the short-run. We discussed in previous sections
16
that the Fisher equation is widely supported by many studies. But the PPP and the uncovered
Overall, both nominal interest rate and price level are measured different by the country
governments. Consequently, the results may diverge from the international finance theory. Even
though, the domestic markets are increasingly more integrated with international markets. In
contrast, the financial integration under the system of floating exchange rate may not lead to the
RIP due to high exchange rate volatility and the foreign exchange risk premium.
In sum, the RIP is a very interesting model and its theoretical importance is undeniable,
however, recent studies do not support the parity condition. The model is a combination of two
markets, money market, and foreign exchange market, it is a result of both markets simultaneous
equilibrium. Further given the results of this paper, the short-run RIP equilibrium is rejected and
the Long-run is in part supported. Regardless, the RIP will continue to be a concern for
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18
Appendix I
International Monetary Fund. IMF data. International Monetary Fund. n.d. Web. 16 Apr. 2016.
19
International Monetary Fund. IMF data. International Monetary Fund. n.d. Web. 16 Apr. 2016.
20
Appendix II
The UK Real Interest Rate regressed on the UK Real Interest Rate, with OLS,
quarterly rates and frequency 1980q1 2015q4,
21
Appendix III
Normality test for Residuals
22
Appendix IV
The UK Real Interest Rate regressed on the UK Real Interest Rate, with Newey-
West Standard errors,
quarterly rates and frequency 1980q1 2015q4,
23
Appendix V
24
Appendix VI
25
Appendix VII
KPSS test for Real Interest Rate Differential (lags=12)
26
Ordinary Least Squares Estimates
KERNEL=QS, SCHW=12
Parameter Estimates
Standard Approx
Variable DF Estimate Error t Value Pr > |t|
27
KPSS test for Real Interest Rate Differential (lags=2)
KERNEL=QS, AUTO
Parameter Estimates
Standard Approx
Variable DF Estimate Error t Value Pr > |t|
28
Appendix VIII
No trend
29