Five Facts about the UIP Premium

Kalemli-Özcan, Á¹¢ebnem and Liliana Varela

No 16244, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We present five novel facts on the UIP-wedge—the difference between expected USD returns on local currency assets and actual USD asset returns. We focus on emerging markets (EMs) and contrast our new findings with established ones for advanced economies (AEs). The five facts are: 1) Persistent EM-UIP Wedge: The EM-UIP wedge fluctuates but remains positive, indicating a continuous excess currency return both ex-ante and ex-post. 2) Expectation Accuracy: Survey data on agents’ expectations of future exchange rate changes closely align with actual outcomes, demonstrating similar dynamics and Fama coefficients for the EMUIP wedge. 3) Heterogenous Perceptions and Risk Factors: Disagreement among agents about future exchange rate movements is positively correlated with local risk factors and can forecast interest rate differentials. 4) Local Risk and Time-Variability: Local risk factors account for 70% of the variability in the EM-UIP wedge over time, driven by interest rate differentials. 5) Foreign Capital: The EM-UIP wedge relates to foreign investment, exhibiting a negative relationship with capital inflows. These findings underscore the nuanced behavior of the UIP wedge in EMs vs AEs, where EM-UIP wedge more closely reflects compensation for systematic, country-specific, and time-varying risk premia in segmented asset markets.

Keywords: Excess currency returns; Risk premia; Expectations; Policy credibility (search for similar items in EconPapers)
JEL-codes: F21 F32 F41 (search for similar items in EconPapers)
Date: 2022-05
References: Add references at CitEc
Citations: View citations in EconPapers (3)

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