How well does the uncovered interest rate parity theory hold empirically? : An analysis between Sweden and Norway to seek causality between interest rates and exchange rate movements

The empirical performance of theoretical macroeconomic models is an important issue to study. Especially since it is the basis for how many actors view and act in markets. This study examines how well the theory of the uncovered interest rate parity can be confirmed empirically, more specifically how interest rate differentials between countries effect their exchange rate movements. This area is well studied where several studies show the opposite of what the theory predicts, often referred to as “The forward premium puzzle”. In this study using data from the last 30 years, the theory is applied to make a comparison between the two similar countries Sweden and Norway and the United States in the short run. The UIP predicts that a lower domestic interest rate will lead to a future appreciation of the currency. The results provide a clear picture of the opposite, estimating that a lower interest rate leads to exchange rate depreciation, which indicates that there is a risk premium involved.