An incomplete markets explanation of the UIP puzzle

Katrin Rabitsch

No 53, FinMaP-Working Papers from Collaborative EU Project FinMaP - Financial Distortions and Macroeconomic Performance: Expectations, Constraints and Interaction of Agents

Abstract: A large literature attributes failure of uncovered interest rate parity (UIP) to the existence of a timevarying risk premium. This paper presents a mechanism in a simple two-country two-good endowment economy with incomplete markets that generates sizeable deviations from UIP. In a parameterization where international wealth effects are important, liquidity constraints on an internationally traded bond and agents' strong resulting precautionary motives successfully generates a time-varying risk premium: countries that have accumulated large outstanding external positions have, being closer to the constraints, stronger precautionary motives and their asset carries a risk premium.

Keywords: Uncovered Interest Rate Parity; Incomplete Markets 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: 2016
New Economics Papers: this item is included in nep-dge, nep-opm and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:fmpwps:53

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