UNCOVERED INTEREST ARBITRAGE, PURCHASING POWER PARITY AND RISK PREMIUMS ON FOREIGN EXCHANGE

The research for this paper focuses on the implied expected exchange rates between the U.S. dollar and the Deutsche Mark. We use one year debt yield and one year inflation forecasts to derive expected exchange rates based on uncovered interest arbitrage and on the purchasing power parity relationship. We also explore the explanatory power of combinations of these two alternative expected exchange rates including what they might reveal regarding exchange rate premiums. Our results indicate that a combination of the two approaches which models a risk premium may be beneficial. We indicate some further work to be done along this line and provide a summary and conclusion based on the work reported here.