As interest rates hit the ZLB, Bussiere and al. reexamine in this paper the Fama puzzle (the finding that ex post depreciation and interest differentials are negatively correlated, contrary to what theory suggests) in order to understand whether the puzzle is a general phenomenon or one that is regime-dependent:
We obtain the following findings. First, Fama’s result is by and large replicated in regressions for the full sample, ranging from 1999 to February 2016. However, the results change if the sample is truncated to apply to only the most recent decade, the period for which interest rates are essentially at zero. For that period, interest differentials correctly signal the right direction of subsequent exchange rate changes, but with a magnitude that is altogether not reconcilable with the arbitrage interpretation of UIP. In other words, we obtain positive coefficients at exactly a time of high risk when it would seem less likely that UIP would hold.
The reversal also appears for non-US dollar-based exchange rates:
In Figure 1, almost all the estimates are negative. In Figure 2, they are almost all positive.
Interest Differentials and Exchange Rate Changes Before and After the Global Crisis
By: Menzie Chinn – University of Wisconsin–Madison
The New Fama Puzzle
Authors: Matthieu Bussiere, Menzie D. Chinn, Laurent Ferrara, Jonas Heipertz
From: Banque de France, University of Wisconsin–Madison, Paris School of Economics
