Panel Data Models and the Uncovered Interest Parity Condition: The Role of Two-Way Unobserved Components

This paper endeavours to show how the specification of the regression testing the uncovered interest parity (UIP) condition
can determine whether or not the hypothesized proportional relationship between international interest rate differences and
exchange rate changes is rejected. Across major currencies, various terms to maturity, different data frequencies and the short
as well as the long time horizon, single-equation regressions partly reject the UIP condition. However, this ‘UIP puzzle’ tends
to disappear when panel data regressions account, for example, for risk premiums by means of two-way unobserved component
specifications with random or fixed effects for both currencies and time periods. The closest concurrence with the UIP condition
arises when specifying the time-specific component as fixed effect, which provides a way to address the potential bias when
unobserved exchange rate risk premiums correlate with interest rates.