An Incomplete Markets Explanation to the UIP Puzzle

Rabitsch, Katrin (2014) An Incomplete Markets Explanation to the UIP Puzzle. Department of Economics Working Paper Series, 171. WU Vienna University of Economics and Business, Vienna.


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A large literature has related the failure of interest rate parity in the foreign exchange market to the existence of a time-varying risk premium. Nevertheless, most modern open economy DSGE models imply a (near) perfect interest rate parity condition. This paper presents a stylized two-country incomplete-markets model in which countries have strong precautionary motives because they face international liquidity constraints, the presence of which successfully generates a time-varying risk premium: the country that has accumulated debt after experiencing relative worse times has stronger precautionary motives and its asset carries a risk premium. (author's abstract)

Item Type: Paper
Keywords: Uncovered Interest Rate Parity / Incomplete Market / Precautionary Savings / Time-Varying Risk
Classification Codes: JEL F31, F41, G12, G15
Divisions: Departments > Volkswirtschaft
Depositing User: Claudia Tering-Raunig
Date Deposited: 01 Apr 2014 07:59
Last Modified: 22 Oct 2019 00:41


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