Long-Run UIP Holds Even in the Short Run

Abstract

The failure of uncovered interest rate parity to explain short-term interest rate movements is well documented. We show that short-term changes in long-term interest rates do help to explain short-term exchange rate movements. The relationship gets stronger over our sample period, as the liquidity of the exchange rate market increases. We also show that controlling for time-varying exchange rate risk also helps to improve the fit of the relationship.