Finance and Financial Management
In this paper, we first review Irving Fisher’s seminal work on UIP and on the closely related equation linking interest rates and inflation. Like Fisher, we find that the failures of UIP are tied in with individual episodes in which errors surrounding exchange-rate expectations have been persistent but in the end transitory. We find considerable commonality in deviations from UIP and PPP suggesting that both of these deviations are driven by a common factor. Using a dynamic latent factor model we find further that deviations from UIP are almost completely due to forecasting errors in exchange rates – a result consistent with those reported by Fisher a century ago.
Campbell, Rachel; Koedijk, Kees; Lothian, James R.; and Mahieu, Ronald, "Irving Fisher, Expectational Errors and the UIP Puzzle" (2007). CRIF Seminar series. Paper 3.