1300 WordsFeb 8, 20176 Pages

In economics, a puzzle occurs when empirical data does not match the expected outcome that theory would predict. One such puzzle is the uncovered interest rate parity, also known as UIP. This specific puzzle is about interest rate differentials and exchange rate fluctuations, and how the empirical findings do not support the theory behind them. In order to further understand this vast research has been conducted on this puzzle in order to attempt to explain why it is occurring. The reason why there is a desire to understand why this is occurring is because one of the foundations of corporate finance is that no arbitrage opportunities are present, but here we see what appears to be one. However, let us first explain what theory says should*…show more content…*

Now looking at several case studies the first being Adrian W. Throop. In his model, he runs four regressions where fluctuations in exchange rate between the dollar and other major currencies are the dependent variables: Trade-Weighted US$, Yen/US$, Mark/US$, and Pound/US$. As for the independent we see the focus on the interest rate change in the domestic and foreign market. He includes a great deal of other information in how he acquires what he calls the real interest rate, and thus account for shocks in the market. This is done to test the hypothesis that sticky price model of exchange rates can explain why this puzzle is occurring with interest rate and exchange rate of foreign currency. Whereas, the null hypothesis is that sticky price model of exchange rates cannot explain why the puzzle is occurring. In conclusion, Throop found that although the sticky model made sense theoretically when put to the test empirically it fell short and was not able to adequately account for the UIP puzzle. Now looking at Alfred V. Guender and his article on UIP he also uses a regression to test the UIP puzzle, however, he believes that the conventional test equation of the UIP hypothesis is plagued by omitted variable bias (Guender, 2014). As such he hypothesis there is an inverse relationship between the exchange rate change and the lagged interest rate differential, and he also takes into account variables that are typically omitted, but do have an impact on the model such

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