An Incomplete Markets Explanation to the UIP puzzle

Publication: Working/Discussion PaperWU Working Paper

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Abstract

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)
Original languageEnglish
DOIs
Publication statusPublished - 1 Apr 2014

Publication series

SeriesDepartment of Economics Working Paper Series
Number171

WU Working Paper Series

  • Department of Economics Working Paper Series

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