Differential risk premiums and the UIP puzzle

Abstract

We respecify the uncovered interest rate parity (UIP) conditions by inverting the market price of the risk (Sharpe ratio) formula. Our empirical model provides new insight indicating that violations to the UIP stem from the existence of a risk premium in the exchange rates and from observed market return differentials being a noisy statistic of the markets’ expected return differentials in our respecified model. Using an integrated macro‐micro structure framework for expected market return differentials improves our model fit and the validity of UIP.

Intermediary asset pricing in currency carry trade returns

“…CR5 is the cumulation of equally weighted average return from those economies in P5. The monthly sample is January 2000-November 2018 markets for developed countries versus emerging market countries (Biswas et al, 2020;Han et al, 2019;Shahzad et al, 2018). For example, Han et al (2019) find that when uncertainty in the US real economy and financial markets increases, weak currencies in emerging economies are confronted by greater variations, while strong currencies in developed economies remain relatively stable.…”

“…Meanwhile, we reexamine the relation between ICR and carry trade excess returns for currencies in developed markets and emerging markets. Previous studies argue that there is potentially a difference in risk exposure in currency markets for developed countries versus emerging market countries (Biswas et al, 2020; Han et al, 2019; Shahzad et al, 2018). For example, Han et al (2019) find that when uncertainty in the US real economy and financial markets increases, weak currencies in emerging economies are confronted by greater variations, while strong currencies in developed economies remain relatively stable.…”

“…The result also holds when we split the sample into pre‐2008 and post‐2008 periods, which reassures us that the baseline results are not driven by exposure to the Great Recession or the zero lower bound (ZLB; Farhi & Gabaix, 2016; Husted et al, 2018). We further partition currencies into developed markets and emerging markets, which allows us to uncover the unstable and differential risk premium of the carry trade in currencies across economies with varying levels of financial development (Biswas et al, 2020; Han et al, 2019; Shahzad et al, 2018). We find that ICR can negatively predict carry trade excess returns in emerging economies, while it fails to explain the excess returns of developed currencies.…”

Exchange rate parities and Taylor rule deviations

“…Two well-known puzzles in international finance arise as a result of the apparent failure of many empirical models to find support for either the PPP (Purchasing Power Parity) or the UIP (Uncovered Interest Rate Parity) relations. Various possible explanations have been offered for these findings including: the low power of standard unit root tests (Murray and Papell, 2005 ); the presence of nonlinearities (Taylor et al, 2001 ; Kapetanios et al, 2003 ; Sarno et al, 2006 ); the failure to take into account the interaction between goods and asset markets (Johansen and Juselius, 1992 ; Juselius, 1995 ); non-tradability of goods (Sarno and Chowdhury, 2003 ) and real frictions (Ford and Horioka, 2017 ) in the case of PPP; the existence of a risk premium (Li et al, 2012 ; Biswas et al, 2020 ); the occurrence of rational bubbles (Obstfeld, 1987 ; Canterbery, 2000 ); or deviations from rationality of market participants (Gregory, 1987 ; Chinn and Quayyum, 2012 ) in the case of UIP.…”

Exchange Rate Parities and Taylor Rule Deviations

“…Two well-known puzzles in international finance arise as a result of the apparent failure of many empirical models to find support for either the PPP (Purchasing Power Parity) or the UIP (Uncovered Interest Rate Parity) relations. Various possible explanations have been offered for these findings including: the low power of standard unit root tests (Murray and Papell, 2005); the presence of nonlinearities (Taylor et al, 2001;Kapetanios et al, 2003;Sarno et al, 2006); the failure to take into account the interaction between goods and asset markets (Johansen and Juselius, 1992;Juselius, 1995); non-tradability of goods (Sarno and Chowdhury, 2003) and real frictions (Ford and Horioka, 2017) in the case of PPP; the existence of a risk premium (Li et al, 2012;Biswas et al, 2020), the occurrence of rational bubbles (Obstfeld, 1987;Canterbery, 2000), or deviations from rationality of market participants (Gregory, 1987;Chinn and Quayyum, 2012) in the case of UIP.…”