Interest parity, cointegration, and the term structure: Testing in an integrated framework

- We develop a unified framework of the expectations hypothesis of the term structure and the uncovered interest parity.
- We test the joint framework using Eurocurrency interest rates.
- We find weak evidence in favor of the proposed joint framework.
- We are able to associate in some cases the common nonstationary stochastic factor with the U.S.-dollar interest rates.

In this paper, we develop a methodology for testing jointly the validity of the expectations hypothesis of the term structure (EHTS) and the uncovered interest rate parity (UIRP) within the framework provided by cointegration theory. For this purpose, we use data on interest rates from the U.S. dollar-Libor, GBP-Libor, and Euro-Libor markets with maturities ranging from 7 days to 12 months. The main findings of our analysis are as follows: (i) we fail to find the correct rank of the cointegration space suggested by our methodology; (ii) with the application of tests for parameter stability in cointegrated models, we show that our cointegration results are sample independent and that the estimated coefficients do not suffer from instabilities in recursive estimations; (iii) from the moving average representation of the model, we estimate the common stochastic trends whose components establish, in the USD/Euro case, the interdependence of interest rates in the formation of the driving forces of the system; (iv) we manage to identify with the two theories a sub-space of the estimated cointegration space.