Interest Rate Differentials, Future Exchange Rate, and Uncovered Interest Parity

There is no doubt that the concept and theory of interest parity received prominence from the exposition of John Maynard Keynes in 1923. However, as the global financial crisis and International finance gain critical attention, the roles of the forward market for foreign exchange and interest parity can no longer be ignored.  As the interest parity links forward and spot exchange market rates together, the uncovered interest rate parity assumption is becoming more difficult to test. Empirical assessments of uncovered interest parity [UIP] as a framework for predicting the future spot exchange rate have received mixed findings since market expectations of the future exchange rates are not directly observable. The predictability questions have ranged from prediction error to questions of whether the predictions are systematically biased. One cannot resist but ask whether the universal rejection in the studies of exchange rate prediction by UIP could be related to the time horizon of data and methodology of estimation. Could it be that UIP has been tested using financial instruments with relatively short maturity terms? This study tends to investigate the validity of UIP and interest rate parity using both short and long-term financial instruments.