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.
| Original language | English |
|---|---|
| Pages (from-to) | 139-167 |
| Number of pages | 29 |
| Journal | Financial Management |
| Volume | 50 |
| Issue number | 1 |
| DOIs | |
| State | Published - 1 Mar 2021 |
Bibliographical note
Publisher Copyright:© 2020 Financial Management Association International
Funding
We thank Bing Han (Editor) and an anonymous referee, as well as Cheol Eun, Abrar Fitwi, Prakash Loungani, Charli Tandja Mbianda, Asani Sarkar, and seminar participants at the 2017 Eastern Finance Association Annual Meetings and the 2017 Financial Management Association Annual Meetings for helpful comments and suggestions. All errors are the sole responsibility of the authors.
| Funders | Funder number |
|---|---|
| Eastern Finance Association |
Keywords
- Foreign exchange market
- Order flows
- Risk premium
- Uncovered interest rate parity