Skip to main content
placeholder image

Testing for the uncovered interest parity condition in a small open economy: A state space modelling approach

Journal Article


Abstract


  • Do interest rate differentials smoothly mirror the changes in the exchange rate between a small open economy and a large emerging market economy? The literature provides conflicting views on the validity of the uncovered interest parity condition (UIP), including its size and factors influencing the risk premium. We examine the validity of the UIP condition between Nepal and India using time-series data covering the period 1989 – 2019. A state space modelling approach based on the Kalman filter analysis is applied to simulate the risk premium. We find that the UIP condition does not hold for the Nepalese Rupee. A time-varying persistent negative risk premium that dominantly explains interest rate differentials is, instead, found. These findings imply that Nepalese residents prefer to hold foreign assets and continually expect future devaluations of the domestic currency. These present obstacles to developing domestic financial markets and the implementation of a market oriented monetary policy.

Publication Date


  • 2022

Citation


  • Bhatta, G. R., Nepal, R., Harvie, C., & Jayanthakumaran, K. (2022). Testing for the uncovered interest parity condition in a small open economy: A state space modelling approach. Journal of Asian Economics, 82. doi:10.1016/j.asieco.2022.101525

Scopus Eid


  • 2-s2.0-85135386103

Web Of Science Accession Number


Volume


  • 82

Abstract


  • Do interest rate differentials smoothly mirror the changes in the exchange rate between a small open economy and a large emerging market economy? The literature provides conflicting views on the validity of the uncovered interest parity condition (UIP), including its size and factors influencing the risk premium. We examine the validity of the UIP condition between Nepal and India using time-series data covering the period 1989 – 2019. A state space modelling approach based on the Kalman filter analysis is applied to simulate the risk premium. We find that the UIP condition does not hold for the Nepalese Rupee. A time-varying persistent negative risk premium that dominantly explains interest rate differentials is, instead, found. These findings imply that Nepalese residents prefer to hold foreign assets and continually expect future devaluations of the domestic currency. These present obstacles to developing domestic financial markets and the implementation of a market oriented monetary policy.

Publication Date


  • 2022

Citation


  • Bhatta, G. R., Nepal, R., Harvie, C., & Jayanthakumaran, K. (2022). Testing for the uncovered interest parity condition in a small open economy: A state space modelling approach. Journal of Asian Economics, 82. doi:10.1016/j.asieco.2022.101525

Scopus Eid


  • 2-s2.0-85135386103

Web Of Science Accession Number


Volume


  • 82