Depreciation expectations and interest rate differentials: Are there regime switches? The Peruvian case

This paper presents an econometric assessment of the uncovered interest parity (UIP) for Peruvian financial instruments and documents the main empirical regularities in this relationship. The information contents of interest rate differentials about depreciation expectations are assessed under different econometric specifications. In the case of Peru, linear approximations along with periods of relatively high expected inflation suggest that UIP would hold on average over the short term (contrary to international evidence). Alternatively, with price-stability periods (as in a fully-fledged inflation targeting scheme), linear representations show opposite evidence to UIP. When both scenarios are included over a given sample size, regime switching models distinguish between periods consistent with UIP and those periods in which UIP is not so relevant. In particular, Markov switching models signal the importance of foreign exchange volatility to assess UIP validity.