Interest rates and exchange rate movements: analyzing short-term investments in long-term bonds

Tests of the uncovered interest rate parity (UIP) are subject to various data problems when long-term interest rates are applied: due to the long investment period, time intervals for measuring exchange rate movements are usually overlapping and therefore not independent. This shortfall can be prevented by considering short-term investments in long-term bonds instead of investments to maturity. This article analyzes the explanatory power of long-term interest rates with regard to 1- and 3-month exchange rate movements by relating return differences from 1- and 3-month investments in domestic and foreign 10-year government bonds to nine different exchange rates. From a Swiss perspective, there is only weak support for an interrelation between return differences and the corresponding exchange rate movements, whereas from a US perspective, the resulting estimates are much more in line with UIP.