An Empirical Investigation of Interest Rate Differentials and Long-Term Movements of AUD/NZD and USD/NZD

Abstract

This research examines the validity of Uncovered Interest Parity (UIP) for New Zealand’s two most critical currency pairs, AUD/NZD and USD/NZD, over the 2015Q3–2025Q2 period. To the best of the author’s knowledge, this is the first empirical analysis to specifically test a state-dependent UIP framework on the New Zealand dollar, explicitly interacting interest-rate differentials with global risk (VIX) to capture time-varying risk premia. The empirical strategy employs forward-looking, backward-looking, and expectations-based specifications, alongside the VIX-augmented framework. For AUD/NZD, the results suggests that the cross-rate is anchored by fundamental economic linkages, reflecting New Zealand’s close ties to Australia through free trade agreements and shared commodity export cycles. In contrast, USD/NZD exhibits no stable long-run equilibrium, behaving instead as a risk-sensitive asset driven by global sentiment rather than interest-rate differentials. In the short run, standard UIP fails for both pairs, consistent with the "forward premium puzzle," where high-yield currencies often appreciate rather than depreciate. While the VIX-augmented regression yields limited statistical significance, qualitative evidence confirms that uncertainty shocks (such as COVID-19) temporarily decouple exchange rates from fundamentals. These results are subject to key data limitations identified in this study, specifically the smoothing effect of quarterly data and the lack of survey-based expectations data for the AUD/NZD pair. Ultimately, this study provides updated evidence that UIP transmission in a small open economy is regime-dependent. The results suggest that while AUD/NZD allows for passive hedging strategies based on long-run mean reversion, whereas USD/NZD requires active risk management to mitigate exposure to global volatility shocks.