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Differential risk premiums and the UIP puzzle
Author(s) -
Biswas Rita,
Piccotti Louis R.,
Schreiber Ben Z.
Publication year - 2020
Publication title -
financial management
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 1.647
H-Index - 68
eISSN - 1755-053X
pISSN - 0046-3892
DOI - 10.1111/fima.12314
Subject(s) - economics , interest rate parity , risk premium , macro , statistic , econometrics , financial economics , exchange rate , differential (mechanical device) , rate of return , sharpe ratio , risk–return spectrum , expected return , monetary economics , mathematics , statistics , finance , computer science , portfolio , engineering , programming language , aerospace engineering
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.