Testing the uncovered interest parity using traded volatility, a time-varying risk premium and heterogeneous expectations

This paper carries out an empirical investigation of an extended version of Flood and Marion's (2000, self-fulfilling risk predictions: an application to speculative attacks. Journal of International Economics 50, 245-268) UIP model, which incorporates a nonlinear time-varying risk premium that depends on both the expected variance of the future exchange rate and the relative worldwide private holdings of domestic and foreign government bonds. A novel contribution of our paper is the use of traded currency volatility, which is directly observable in the market place, to measure expectations about the future volatility of the exchange rate. Another contribution is the explicit modelling of heterogeneous exchange rate expectations formed by forward-looking fundamentalists and backward-looking chartists. Our overall empirical evidence provides strong support for the extended nonlinear UIP model. We also investigate for the first time the role of traded volatility in the dynamic behaviour of exchange rates, and find that high currency volatility is likely to produce oscillatory and unstable exchange rate paths. (c) 2006 Elsevier Ltd. All rights reserved.