Nonlinearity in the reaction of the foreign exchange market to interest rate differentials: evidence from a small open economy with a long-term peg

This article incorporates the Castle and Hendry (2010) portmanteau test into an Exponential Generalized Autoregressive Conditional Hetroscedasticity in Mean (EGARCH-M) model to investigate nonlinearities in the reaction of daily foreign exchange activity to the interest rate differential between the US and Barbados -- a small open economy which has been pegged to the US dollar for over 35 years. The results suggest that changes in the interest differential have a significant and nonlinear effect on the Barbadian foreign exchange market. The linear spread term is positive, and so is in line with a theory of uncovered interest parity for an economy with a fixed exchange rate. But, all other spread coefficients have a negative sign, implying that asymmetry is present. Thus, it is possible that there is a threshold at which foreign currencies no longer conform to the uncovered interest parity condition, but rather are negatively correlated with interest spreads. Finally, these findings were consistent in the pre-financial crisis analysis.