Why does uncovered interest parity fail empirically?

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AcadiFi · Accepted Answer

Uncovered interest parity (UIP) predicts that expected currency depreciation equals the interest rate differential. If USD rates are 4.5% and JPY rates are 0.3%, UIP implies JPY should appreciate 4.2% annually in expectation, making expected USD and JPY deposits identical in one currency.

Empirically, UIP fails because it requires risk-neutral investors with rational expectations. Instead, currencies with high rates tend to appreciate (forward premium puzzle), generating persistent carry-trade profits. Possible explanations: (1) time-varying risk premium - investors demand compensation for crash risk in high-yielders; (2) peso problems - rare disasters haven't materialized in sample but are correctly priced; (3) expectational errors - surveys show forecasters under-weight interest differentials; (4) limits to arbitrage - capital controls and institutional frictions prevent full exploitation.

Sunfield Macro tested UIP across 30 currencies over 45 years. Coefficient on interest differential in Fama regression averaged -0.8 (UIP predicts +1.0), meaning high-rate currencies appreciate rather than depreciate. In crisis periods the coefficient flips positive: March 2020 saw all high-yield EM currencies collapse 10-20%. UIP holds conditionally on being in a calm regime, which traders can partially identify using volatility filters (VIX above 30 signals UIP regime change).

Why does uncovered interest parity fail empirically?

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