Does Uncovered Interest rate Parity Hold After All?

This paper tests Uncovered Interest Rate Parity (UIP) using LIBOR rates for the major international currencies for the period January 2001 to December 2008. We find that UIP generally holds over a short-term horizon for individual and groups of currencies. Our results suggest that it is important to take the cross correlation between currencies into account. We also find that ‘state dependence’ plays an important role for currencies with a negative interest differential vis-à-vis the US. This ‘state dependence’ could also be instrumental in explaining exchange rate overshooting.