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Testing the Uncovered Interest Parity Condition

Between the USA and Brazil: A Model using

MGARCH and Realized Volatilities

Lucas Moreira Villela Emerson Fernandes Marçal

January 21, 2019

This study tests the uncovered interest rate parity between the Brazil-
ian and American markets during the period of June 1986 to August 2016.
The validation of the uncovered parity condition implies efficiency be-
tween markets. The condition is tested through the VECM methodology
proposed in Engle and Granger (1987) utilizing the cointegrating vector
testing the uncovered parity on the long term. The Multivariate GARCH
model proposed by Bollerslev, Engle, and Wooldridge (1988) is used, mod-
eling not only the mean but the variance of the model’s variables, that way
controlling the ARCH (autoregressive conditional heteroscedastic) effect
in financial series. The variances of the variables are estimated through
the Realized Variance estimator, first proposed in Andersen and Boller-
slev (1998), in which the authors show it to be a consistent estimate of the
integrated variance of a given process. The results validate the uncovered
interest parity, showing it to be valid as a long-term equilibrium and that
any deviation is corrected in the long term through the exchange rate
between Brazil and the United States.

1 Introduction
The uncovered interest rate parity (UIP) is an expected relation in the ex-
change rate market that, when valid, shows that investments with equal returns
will yield the same result regardless if the investment is being made in the in-
vestor’s native country or in a foreign country MacDonald (2007). In markets
where the UIP is valid there is no possibility of arbitrage for investors, as such
the UIP is regarded as a inter-market efficiency measure Sarno (2003).
In this article we test the validity of the UIP between the Brazilian and
the American markets. Our model takes in account the period between June
1986 and August 2016. To test the UIP hypothesis we model the USA-Brazil
exchange rate based on it’s time series and the basic interest rate of both coun-
tries. The results of our model will show whether the UIP is corroborated or
To accurately model the phenomena in question we utilize the VEC (Vector
Error Correcting) methodology first presented in Engle and Granger (1987). In
conjunction we utilize a GARCH model as established in Bollerslev (1986) to
better account for stylized facts inherent in financial time series, among those
excess kurtosis and volatility clustering as pointed out in Mandelbrot (1997).

Our model also uses realized volatility (RV) estimators proposed in Andersen
and Bollerslev (1998) to get consistent estimations of the integrated variance of
a time series.
Our results show positive results for the validity of the UIP condition. with
the Error Correcting Vector (ECM) showing statistical significance and results
that corroborate the UIP.
On the next section features a brief review of the UIP condition followed by
our econometric model and finally our results and conclusions.

2 The Uncovered Interest Rate Parity (UIP)

The Uncovered Interest Rate Parity (UIP) is a theoretical model to un-
derstand the relationship between interest rates and exchange rates between
international markets (MacDonald, 2007) one of the conclusions given by the
UIP is that if the condition holds, there is no possibility of arbitrage between
markets (MacDonald, 2007). As such results from empirical models that test
the validity of the UIP are used as a proxy for measuring the efficiency between
two international markets (Sarno, 2003).
In a markets that are efficient, There is no possibility of arbitrage between
different investments, by that we mean that investment of similar risk and return
will yield the same return, independently of whether the investor is domestic or
foreign (MacDonald, 2007)
Mathematically, the UIP is represented in equation (1):
St+k − St = it − i∗t (1)
In which St+k is the spot exchange rate in a future moment k periods from
the present period t. The superscript e indicates that this is the expected value
of o the exchange rate as expected by the market.St is the nominal value of the
spot exchange rate today and (it − i∗t ) is the differential between the domestic
interest rate and the foreign interest rate. All values are in their logarithmic
form MacDonald (2007); Sarno (2003).
The empirical literature surrounding the theme of the UIP is conflicting hav-
ing empirical papers that utilize a variety of empirical tools and models testing
the condition in a variety of country dyads and groups of countries. Their
findings vary between corroborating the UIP with empirical evidence (Byrne &
Nagayasu, 2012; Czudaj & Prüser, 2015; Wagner, 2012), being unable to find any
proof of the condition holding (Georgoutsos & Kouretas, 2016; Juselius & Mac-
Donald, 2004; Lily, Kogid, Mulok, & Asid, 2012; Živkov, Njegić, Momčilović, &
Milenković, 2016) and mixed results with the condition holding between certain
countries and not in some (Chang & Su, 2015; NUSAIR, 2013).
In Brazil, the few tests of the UIP are always between the Brazilian and
American markets. The works of dos Santos Souza e Silva and Curado (2013)
and Cieplinski (2015) find no evidence for the UIP’s validity. In opposition the
work of Marçal, Pereira, and dos Santos Filho (2003) finds through a cointe-
grated VAR evidence for the UIP.

3 Data
In the following section we present the relevant data captured to be used
in our empirical model. First, we present the raw data and it’s characteristics,
followed by transformed data that was used in the empirical model.

3.1 Raw Data

3.1.1 Commercial Exchange Rate
Figure 1 shows the exchange rate between the Brazilian Real and the Amer-
ican Dollar. The exchange rate time series was captured directly from the
Brazilian Central Bank and goes from 01/02/1985 to 19/08/2016 with a daily
frequency. The daily values are composed by the mean of intraday transactions.

Figure 1: Commercial Exchange Rate - Real X Dolar - Daily

3.1.2 Brazilian Base Interest Rate (SELIC)

Figure 2 shows the evolution of the Brazilian base interest rate through time.
The interest rate time series was captured directly from the Brazilian Central
Bank and goes from 06/04/1986 to 20/09/2016 with a daily frequency. The
interest rate is in a per month scale.

Figure 2: SELIC Interest Rate (% p.m) - Daily

3.1.3 American Base Interest Rate (Federal Funds)

Figure 3 shows the evolution of the American base interest rate through time.
The interest rate time series was captured directly from the Federal Reserve and
goes from 07/01/1954 to 26/09/2016 with a daily frequency. The interest rate
is in a per year scale.

Figure 3: Federal Fund Interest Rate (% p.y) - Daily

3.2 Transformed Data

3.2.1 Second Difference of Commercial Exchange Rate Returns (DDLEx)
Using the standard augmented Dickey-Fuller unit root test we determined
that the first difference of the exchange rate was insufficient in making the
variable stationary as such the second difference was used. Figure 4 shows the
transformed variable’s graph, while table 1 shows the unit root test.

Figure 4: Second Difference of Monthly Exchange Rate Returns (DDLEx)

Table 1: ADF test for DDLEx

D-Lag t-adf Beta Y 1 Sigma
0 -27.82*** -0.35781 0.07342

3.2.2 First Difference of SELIC Returns (DLSELIC)

The first difference of the SELIC rate returns was taken to make the variable
stationary. Figure 5 show it’s graph and table 2 shows the ADF test.

Figure 5: First Difference of Monthly SELIC Returns (DLSELIC)

Table 2: ADF test for DLSELIC

D-Lag t-adf Beta Y 1 Sigma
0 -16.02 0.18519 0.03288

3.2.3 First Difference of Federal Fund rate Returns (DLFF)
The first difference of the Federal Fund rate returns was taken to make the
variable stationary. Figure 6 show it’s graph and table 3 shows the ADF test.

Figure 6: First Difference of Monthly Federal Fund Returns (DLFF)

Table 3: ADF test for DLFF

D-Lag t-adf Beta Y 1 Sigma
0 -30.72 -0.43502 0.000622

3.2.4 Error Correcting Model (ECM)

Following the methodology first put forth by Engle and Granger (1987) and
then expanded in (Johansen, 1991) and informed by the restrictions imposed by
the the UIP theory, we build an ECM following the equation:

ECMt = LSELICt − LF Ft − DLExt (2)

The result is presented in figure 7 and an ADF test is made to show the
stationarity of this ECM, the results are shown in table 4.

Figure 7: Error Correcting Model (ECM)

Table 4: ADF Test for ECM

D-Lag t-adf Beta Y 1 Sigma
0 -17.54 0.0895 0.05269

3.2.5 Realized Volatility Estimator for ECM (VR ECM)

The realized volatility estimator proposed in (Andersen & Bollerslev, 1998)
is proven to be a consistent estimator of the integrated variance of a process.
We utilize daily data to avoid the bias generated by microstructure market
noise. We utilize the realized volatility estimator in both the mean and variance
equation of our MGARCH model. The estimator is calculated according to the
following equation proposed in (Andersen & Bollerslev, 1998):
V Rt = rt,i (3)

In which, r2 are the quadratic returns, t is the counter for lower frequency
period and i is a counter from 1 to M . where M is the maximum high frequency
observations. In this article, t represents the monthly frequency and i represents
the daily frequency.
On figure 8 we see the graph of the VR ECM.

Figure 8: Realized Volatility of ECM (VR ECM)

4 Model
To properly capture the dynamic of this phenomena and empirically validate
the UIP, our empirical model has utilized several different econometric tools. To
capture the volatility clustering effect inherent to financial time series, as evi-
denced in Mandelbrot (1997), we utilize the GARCH methodology put forth in
Bollerslev (1986) due to modeling both the mean and volatility of a time series.
Due to all series being integrated, we also utilize the Vector Error Correcting
Model put forth by Engle and Granger (1987) and impose in the Error Correct-
ing Vector the UIP condition, in which the domestic and foreign interest rates
and the exchange rate have to be equal in the long term.
Due to the multivariate nature of the VECM model, we utilize the MGARCH
model, first used in Bollerslev et al. (1988). Finally, we add the realized volatility
estimator to both the mean and variance equations.
As a result our model is given by the following equations:

yt = Cxt + εt (4)
ht = $ + γV R + α(εt−1 ε0t−1 ) + βht−1 (5)
εt = ht zt (6)

In equation 4, yt is a vector containing the variabels DDLExt and DLSELICt .

xt is a vector with the variables DDLExt−1 , DLSELICt−1 , DLF Ft , DLF Ft−1 ,
ECMt−1 and V R ECMt−1 .
In equation 5, $ is the unconditioned variance-covariance matrix. V R is
a vector containing the variable V R ECM . The term (εt−1 ε0t−1 ) conditions
the variance on the model’s errors while ht−1 conditions the contemporaneous
variance with the past variance.
To better capture the excess kurtosis related to financial time series, inference
is made using the T distribution and not a standard Gaussian distribution.
In our model the parameter related to the variable ECMt−1 is our parameter
of interest, it represents the long term relationship given by the UIP. If this
parameter is statistically significant it will point to the corroboration of the UIP
between the Brazilian and American markets. However, if this parameter is not

statistically significant in any equation, we have no evidence for the validity of
UIP condition in these markets.
As the proposed model is a bivariate model, only one cointegrating relation-
ship is possible, therefore it is also expected that the parameter for the variable
ECMt−1 be statistically significant in one one of the equation of the model,
that will point to how the system adjusts itself towards equilibrium, with the
equation with the significant parameter being the one doing the adjustment.

4.1 Results
The following table shows the results of our model.

Table 5: Results for Equation DDLEx

Mean Equation
Variable Coef. St. Error T- Stat P-value
Constant -0.0044 0.001472 -3.009 0.0028***
DDLEx 1 -0.2156 0.073164 -2.947 0.0034***
DLSELIC 1 -0.0289 0.16336 -0.177 0.8597
DLFF 0.5593 0.66227 0.845 0.399
DLFF 1 0.5431 0.88005 0.617 0.5376
ECM 1 0.4697 0.12309 3.816 0.0002***
VR ECM 1 -0.0003 0.000001 -29.39 0.0000***
Variance Equation
Variable Coef. St. Error T- Stat P-value
Uncond. Variance 0.0021 0.001112 1.898 0.0586*
Uncond, Covariance -0.0002 0.000243 -0.725 0.469
b 1 0.8144 0.027711 29.39 0.0000***
a 1 0.5803 0.053843 10.78 0.0000***
VR ECM 1 -0.0042 0.001844 -2.296 0.0223**
P-values marked with * are significant at a 10% level, ** at a 5% level,
and *** at a 1%.

Table 6: Results for Equation DLSELIC
Mean Equation
Variable Coef. St. Error T- Stat P-value
Constant 0 0.000009 -0.498 0.6185
DDLEx 1 -0.0002 0.001718 -0.104 0.9174
DLSELIC 1 -0.283 0.091278 -3.1 0.0021***
DLFF -0.0653 0.12452 -0.524 0.6005
DLFF 1 -0.1114 0.20911 -0.533 0.5946
ECM 1 -0.0017 0.001975 -0.852 0.3948
VR ECM 1 -0.0004 0.000005 -9.587 0.0000***
Variance Equation
Variable Coef. St. Error T- Stat P-value
Uncond. Variance 0.0004 0.00017 2.567 0.0107**
Uncond. Covariance -0.0002 0.000243 -0.725 0.469
b 1 0.7916 0.021741 36.41 0.0000***
a 1 0.611 0.050072 12.2 0.0000***
VR ECM 1 -0.0083 0.002963 -2.805 0.0053***
P-values marked with * are significant at a 10% level, ** at a 5% level, and
*** at a 1%.

WE observe that the parameter of interest for ECM1 shows statistical sig-
nificance in the equation for the DDLEx variable. To assess the quality of
these results we put our model through the standard tests of the Gauss-Markov
assumptions and other tests relevant to our model.

4.2 Autocorrelation Tests

The following tables presents the test statistics for the Box/Pierce auto-
correlation test using the model’s standardized residuals. We present the test
statistics for 5, 10, 20 and 50 lags. The test’s null hypothesis is an absence of

Table 7: Q Autocorrelation Statistics for DDLEx

Lags Test Statistics P-Value
Q(5) 0.4116 0.995003
Q(10) 0.4594 0.999996
Q(20) 0.9306 1.000000
Q(50) 3.0442 1.000000

Table 8: Q Autocorrelation Statistics for DLSELIC
Lags Test Statistics P-Value
Q(5) 7.2685 0.20143
Q(10) 14.1049 0.16826
Q(20) 28.0551 0.1081
Q(50) 51.2632 0.42392

Based on the test statistics, we show that the model has controlled the
autocorrelation effects. em both time series.

4.3 ARCH Test

On tables 9 and 10 we present test statistics for the Box/Pierce ARCH effect
test done using the model’s quadratic standardized residuals. The test statistics
for 5, 10, 20 and 50 lags are presented. The test’s null hypothesis is an absence
of the ARCH effect.

Table 9: Q ARCH Test Statistics for DDLEx

Lags Test Statistics P-Value
Q(5) 0.0293 0.99999
Q(10) 0.0616 1.000000
Q(20) 0.1272 1.000000
Q(50) 0.3449 1.000000

Table 10: Q ARCH Test Statistics for DLSELIC

Lags Test Statistics P-Value
Q(5) 0.0987 0.99984
Q(10) 1.6945 0.99819
Q(20) 2.9704 1.000000
Q(50) 5.2897 1.000000

Based on the ARCH tests presented, we determined that the model fully
captured the ARCH effect.

4.4 Normality Tests

Normality is the fifth and only optional Gauss-Markov assumption. While
it’s presence is not necessary for non-biased and consistent parameters, it’s
presence implies not only that the estimators are non biased and consistent but
also the best linear unbiased estimators (BLUE). The following tables show tests
for asymmetry, excess kurtosis and the Jarque-Bera normality test.

Table 11: Normality Tests for DDLEx
Test Test Statistic T-Test P-Value
Asymmetry 12.7 98.77 0.0000
Excess Kurtosis 237.62 926.64 0.0000
Jarque-Bera Normality Test 856630 .NaN 0.0000

Table 12: Normality Tests for DLSELIC

Test Test Statistic T-Test P-Value
Asymmetry 2.69 20.92 0.0000
Excess Kurtosis 37.1 144.67 0.0000
Jarque-Bera Normality Test 21079 .NaN 0.0000

Based on the test statistics presented, we observe residuals are not normal
in the model.

4.5 Weak Exogeneity Test

We apply the weak exogeneity test by variable addition put forth in Urbain
(1993) to test if the weak exogeneity condition exists between the two time se-
ries being modeled. If there is, it is possible to simplify our model to a more
parsimonious univariate model. The test consists of estimating the multivariate
model and adding the model’s residuals to a univariate model with the same
specification as the multivariate model. The residuals being statistically signif-
icant in the model implies that the relation between time series is not weakly
exogenous, and the full multivariate model must be maintained.
In our model, we sought to test if DLSELIC is weakly exogenous in rela-
tion to DDLEx. We estimate a GARCH(1,1) model with the dependent vari-
able DDLExt and independent variables DDLExt−1 , DLSELICt−1 , DLF Ft ,
DLF Ft−1 , ECMt−1 , V R ECMt−1 . The model results are presented in table
Based on the results of this equation, we see that the residuals of DLSELIC
are significant in the model, pointing to DLSELIC being not weakly exogenous
in relation to DDLEx.

4.6 Conditional Correlation

Figure 9 below shows the conditional correlation between the two estima-

Table 13: Results for Weak Exogeneity Test
Mean Equation
Variable Coef. St. Error T- Stat P-value
Constant -0.00434 0.001746 -2.488 0.0133**
DDLEx 1 -0.20755 0.073949 -2.807 0.0053***
DLSELIC 1 -0.12867 0.10423 -1.234 0.2179
DLFF 0.20976 0.74239 0.283 0.7777
DLFF 1 -0.04456 0.86549 -0.051 0.959
ECM 1 0.48491 0.11179 4.338 0.0000***
VR ECM 1 -0.00033 0.000001 -8.083 0.0000***
Res DLSELIC 1.00712 0.094215 10.69 0.0000***
Variance Equation
Variable Coef. St. Error T- Stat P-value
Uncond. Variance 0.00188 0.001159 1.623 0.1054
b1 0.79281 0.049556 16 0.0000***
a1 0.60946 0.081033 7.521 0.0000***
VR ECM 1 -0.00551 0.004282 -1.286 0.1994

Figure 9: Conditional Correlation

4.7 Conditional Variances

Figure 10 shows the conditional variance of both estimations.

Figure 10: Conditional Variances

4.8 Standardized Residuals

Figure 11 sohws the model’s standardized residuals.

Figure 11: Standardized Residuals

5 Conclusion
The objective of this article is to empirically test the Uncovered Interest Par-
ity (UIP) condition between the Brazilian and the American market. Finding
evidences of this condition being valid is tantamount to saying there is efficiency
between markets, blocking investors from performing arbitrage.
The empirical literature presents work both proving and disproving the UIP
in different conditions. Works like Juselius and MacDonald (2004), Lily et al.
(2012), Živkov et al. (2016) show that the condition does not hold empirically.
in contrat, works like Marçal et al. (2003), Wagner (2012), NUSAIR (2013) show
the UIP is valid.
In our work, based on the results of our model, we observe that ECMt−1 is
statistically significant in the equation modeling the Real/Dollar exchange rate,
this shows that the long term relationship between the series that form the UIP

have a long term equilibrium relationship and that when the relation is outside
of equilibrium the exchange rate corrects to move towards it.

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