An Incomplete Markets Explanation to the UIP Puzzle

Katrin Rabitsch ()
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Katrin Rabitsch: Department of Economics, Vienna University of Economics and Business

Department of Economics Working Papers from Vienna University of Economics and Business, Department of Economics

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.

Keywords: Uncovered Interest Rate Parity; Incomplete Market; Precautionary Savings; Time-Varying Risk Premium (search for similar items in EconPapers)
JEL-codes: F31 F41 G12 G15 (search for similar items in EconPapers)
Date: 2014-03
New Economics Papers: this item is included in nep-dge, nep-ger, nep-mon and nep-opm
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