Uncovered interest rate parity (UIRP) provides a crucial theoretical concept for many models in international finance and international monetary economics. Though theoretically sound, the problem, however, is that UIRP does not seem to hold up well empirically. Typically, econometric tests not only reject the null hypothesis, but also find significant slope coefficients with the wrong sign. In this paper, we argued the validity of UIRP violation that has been so widely documented as a coincidence or not. Variables used in this study are spot exchange rate and interest rate. Using quarterly edata span from 1998Q1 to 2010Q3, we run conventional regressions and simple GARCH analysis on UIRP for the case of Malaysia-UK, Malaysia-Japan and Malaysia-Singapore. Nevertheless, the empirical results show that these relationships do not support the UIRP in all cases. We, therefore, cannot reject the validity of UIRP violation such as in widely documented literature reviews. In addition, we also find that traditional (conventional) regressions on UIRP yield positive slope estimates for both Malaysia-UK and Malaysia-Japan cases, whereby for the case of Malaysia-Singapore, the beta slope estimates has a wrong sign (negative value). The result also shows that the UIRP deviation for the case of Malaysia-Singapore has the smallest standard deviation. Moreover, the volatility analysis on the UIRP deviation using simple GARCH analysis revealed that there are significant ARCH and GARCH effects in the case of Malaysia-Singapore, and it seem to be persistence in the long term period. In addition, the empirical investigation on the impact of the interest rate volatility shocks on UIRP deviation does not exist in any cases.

Uncovered interest rate parity (UIRP) is one of the fundamental relationships in international financial markets and constituting an essential basis of some main exchange rate determination theories (Hilde, 2009). It states that the nominal interest rate differential between two countries must be equivalent to or should be an unbiased predictor of the future change in the spot exchange rate. Therefore, the investors’ expected return on the domestic and foreign assets expressed in the same currency should be equal regardless of the national markets within which the foreign deposit is invested. The failure of the interest rate differential to be the unbiased predictor of the future exchange rate change is referred as the uncovered interest rate parity puzzle (Cook, 2009).

Thus, if UIRP holds, investors cannot gain an arbitrage opportunity due to high yield currency is expected to depreciate by an amount approximately equal to the interest rate differential between two countries. A violation of this relationship indicates that capital markets are not efficient and there is a possibility of arbitrage opportunity (see cook, 2009; Frankel, 1992). Besides, any finding reflecting reverse relationship is called forward premium puzzle (see Bansal & Dahlquist, 2000; Cook, 2009).

The basic assumption underlying UIRP is the efficient market hypothesis where the price should fully reflect all the information available to the market participants and thus no profitable opportunities will be possible in the market (Erdemlioglu & Alper, 2007). This means that exchange rates will quickly adjust to any new information, which should immediately be reflected in the exchange rate. Furthermore, it can be considered as a joint hypothesis that the market participants have rational expectations, and that they are risk neutral. If these assumptions are valid and UIRP holds then the expected return from holding one currency rather than another is cancelled out by the opportunity cost of holding funds in that currency versus another.

Even though many emerging markets have started liberalizing their financial markets in the late 1980s and the early 1990s, but their degrees of financial liberalization are still far behind from the developed markets (Alper, Ardic & Fendoglu, 2007). Alper et al. indicated that emerging markets have weaker macroeconomic fundamentals, more volatile economic conditions, shallower financial markets, and incomplete institutional reforms. Therefore, these characteristics may violate the assumptions of the efficient market hypothesis contributing to the deviations from the UIRP conditions. In other words, the UIRP condition is less likely to hold in emerging markets than in developed economies but to what extent?

Earlier empirical literature on the UIRP condition mostly focuses on developed economies rather than emerging markets because of lack of data (Pasricha, 2006). Recently, increases in the degree of financial liberalization in emerging markets enabled many researchers to analyze foreign exchange market efficiency in these economies (Alper et al., 2007). It is the lack of a comprehensive survey reviewing this recent literature in emerging market, especially Malaysia that motivates this study.

As the result of that, the purpose of this paper is to examine the UIRP condition in Malaysia following the restructuring Malaysian economic after the Asian Crisis 1997 aftermath using the conventional regressions and simple GARCH analysis by looking at the Malaysia-U.K, Malaysia-Singapore and Malaysia-Japan cases. The structure of the paper is as follows: UIRP and the selected review of empirical testing of this condition are discussed in the next section. In section 3, we describe the data set and methodology. Section 4 and 5 present the empirical results and conclusion respectively.

SELECTED LITERATURE REVIEW

UIRP has been studied for many different currencies, time-periods and interest rates maturity horizons (mainly in the developed markets) but the majority of the papers rejected the UIRP condition (α = 0, β = 1) empirically (e.g Cuiabano & Divino, 2010; Huisman, Koedijk, Koo & Nissen, 1998; King, 1998; Pasricha, 2006). Some of the reasons of this deviation are the existence of (time varying) risk premiums, peso-problems, market inefficiencies and neglected persistent autocorrelation in the forward premium., as well as small sample problems (Francis, Hassan and Hunter (2002); Huisman etal., 1998). Surprisingly, some study results indicated the forward puzzle, which is, the forward premium or forward discount (interest rate differential) predicted the expected spot exchange rate change in the wrong direction. Erdemlioglu and