The aim of this thesis is to test UIP by implementing an OLS regression analysis for five currency pairs which, according to CFTC data, global turnover data and carry-to-risk ratios, were among the most popular in the investor community. To increase the significance of this thesis for practitioners, the work will use one-month forward contracts which are used frequently by investors and include bid and ask rates in order to account for transaction costs.
In addition, all currency pairs include the US Dollar for reasons of better liquidity, and therefore tighter bid-ask spreads. Moreover, this thesis will present recent findings in literature which try to explain deviations from UIP. Approaches can be separated by the focus on a risk premium, by irrational market behavior or by learning problems and market inefficiency. While most focus is laid on an explanation by a risk premium, it will be shown that it is crucial to combine the different scientific disciplines in order to solve the forward premium puzzle. In addition to this, the thesis will provide an outlook on the future attractiveness of carry trade strategies.
Table of contents
List of figures
List of tables
List of symbols
1 Introduction
2 Theoretical Framework
2.1 Uncovered Interest Parity
2.2 The Forward Premium Puzzle
3 Testing of UIP
3.1 Data
3.2 Regression equation and excess return formula
3.3 Results and analysis
4 Discussion of recent findings in literature
4.1 Approaches to explain a violation of UIP
4.1.1 Explanation by risk premium and peso problems
4.1.2 Explanation by irrationality
4.1.3 Explanation by learning problems and market inefficiency
4.2 Approaches to explain a partial holding of UIP
4.2.1 Developed and emerging markets
4.2.2 Short term and long term maturities
5 Consequences of recent innovations in the foreign exchange market
6 Conclusion
7 Bibliography
Appendix
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