A wavelet perspective on the real interest parity condition

Abstract

According to uncovered interest parity (UIP) theory, the rates of return on comparable assets should be equal across the world, implying that the exchange rate would adjust to ensure that differences between world interest rates average zero. In addition, real interest parity (RIP) prevails when there is long-run convergence between real returns on assets. The aim of this paper is to examine the mean reverting property of real interest rates and the RIP condition in South Africa, using Wavelet analysis. Wavelet analysis is a superior method of testing the properties of a time series, since it does not require stationarity, yields consistent estimates for the integration order (d), and takes into account complex behaviour. It thus provides an alternate fractional integration method which examines the order of integration of the series. The results show that real interest parity between long term interest rates is not supported, as most of the estimated d values exhibit random walk behaviour. For the short-term interest rates there are limited support for long run mean reversion and long memory, but still no evidence that real interest parity holds. Overall, the real interest rate differentials tend to be random walk, which supports the studies that preceded Moosa and Bhatti (1996).