The LKR/JPY Rate and the UIP

Hiruni Nirmali, Champa Rajapakse

Abstract


Of the main theories that explore on Interest rates and exchange rates, Uncovered Interest Rate Parity (UIP) states that the interest rate differential is an unbiased predictor of the spot exchange rate changes. The impact on investors is that there would be no short term arbitrage profits. Studies based on the relationship between these two variables are rare for developing countries like Sri Lanka. Therefore in order to bridge that gap identified through search for literature, Autoregressive Distributed Lags method was employed here to test the UIP. Monthly data on exchange rates and three month risk free interest rates with regard to the selected major external trader, Japan for the period from 2001-2014 were used for this purpose. The findings reveal that UIP does not hold in the short run but there is evidence for UIP to hold in the long run for Sri Lanka. 

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