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.

fxrett = 0.53 + 0.73irdif ft-1, R^2 = 0.77

(0.06) (0.02)

Where fxret is the monthly return of GBPUSD exchange and irdif f is the interest rate differential between UK and US. Values in parentheses are standard errors.

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

(b) 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.

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

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

fxrett = 0.52 + 0.73irdif ft-1 - 0.01yenrett-1 - 0.02chfrett-1, R^2 = 0.79

(0.04) (0.02) (0.01) (0.03)

Where yenret is the YENUSD return and the 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 the 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.

(e) Using your regression model:

fxrett = 0 + irdiff irdifft-1 + yenret yenrett-1 + chfret chfrett-1 + ut

as an example, briefly explain any TWO of the conditions that must hold in order to make your OLS estimators reliable estimators of the population coefficients. (Again, you only need to explain two of the relevant conditions/assumptions, not all of them)