QUESTION ONE

You are studying Interest Rate Parity, a finance theory that the interest rate differential between foreign and domestic countries is equal to the return on the currency exchange rate. To test the theory, you run the following regression model for the currency exchange rate data between 1979 and 2015. The number of observations is 431.

What is the interpretation of the estimated coefficient values 0.53 and 0.73?

(5 marks)

Test the hypothesis that the slope coefficient is equal to 1 (use a two-sided test with a 5% significance level). Clearly state all steps of the testing procedure, all relevant information you use and how you reach your conclusion.

(15 marks)

Based on the outcome of your hypothesis test in part (b), explain if Interest Rate Parity theory is supported by the empirical evidence?

(5 marks)

d. Now you estimate the following extended regression model that also includes two exchange rate returns:

. where yenret is the YENUSD return and chfret is the CHFUSD return. The R-squared of the new regression model is 0.79. Use this information to test the null hypothesis that coefficients the two new variables are jointly statistically insignificant using the F-test. Clearly state the null and alternative hypotheses, the value of the F-statistic and the critical value you use. Clearly show all steps and explain how you reach your conclusion.