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An Incomplete Markets Explanation to the UIP Puzzle

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  • Rabitsch, Katrin

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)

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  • 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.
    • Handle: RePEc:wiw:wus005:4109
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    References listed on IDEAS

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    Cited by:

    1. Lorenzo Garlappi & Jack Favilukis, 2015. "The Carry Trade and UIP when Markets are Incomplete," 2015 Meeting Papers 242, Society for Economic Dynamics.

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