An Incomplete Markets Explanation of the Uncovered Interest Rate Parity Puzzle | Zendy

Rabitsch Katrin | Zendy

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An Incomplete Markets Explanation of the Uncovered Interest Rate Parity Puzzle

Author(s) -

Rabitsch Katrin

Publication year - 2016

Publication title -

review of international economics

Language(s) - English

Resource type - Journals

SCImago Journal Rank - 0.513

H-Index - 58

eISSN - 1467-9396

pISSN - 0965-7576

DOI - 10.1111/roie.12220

Subject(s) - economics , risk premium , interest rate parity , endowment , precautionary savings , incomplete markets , market liquidity , bond , monetary economics , parity (physics) , interest rate , asset (computer security) , liquidity premium , financial economics , microeconomics , liquidity risk , finance , philosophy , physics , computer security , epistemology , particle physics , computer science

A large literature attributes failure of uncovered interest rate parity (UIP) to the existence of a time‐varying risk premium. This paper presents a mechanism in a simple two‐country two‐good endowment economy with incomplete markets that generates sizeable deviations from UIP. In a parameterization where international wealth effects are important, liquidity constraints on an internationally traded bond and agents’ strong resulting precautionary motives successfully generates a time‐varying risk premium: countries that have accumulated large outstanding external positions have, being closer to the constraints, stronger precautionary motives and their asset carries a risk premium.

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