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Local Deviations from Uncovered Interest Parity: Kernel Smoothing Functions and the Role of Fundamentals


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This paper uses recently developed kernel smoothing regression procedures and uniform confidence bounds to investigate the forward premium anomaly. These new statistical methods estimate the local time varying slope coefficient of the regression of spot returns on the lagged interest rate differential. The uniform confidence bands indicate the extent of the rejections of uncovered interest parity and find remarkable variation in both regimes when the anomaly occurs, and also the magnitude of the slope coefficient estimate.

Of particular interest is the fact that the time varying slope parameter can be substantially explained by fundamentals such as monetary growth rates, and also the volatility of US money growth, which is associated with risk premium in many theoretical mdoels. Hence, the apparent deviations from uncovered interest parity have explanations consistent with monetary models and associated risk premium models.

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