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Differential risk premiums and the UIP puzzle

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  • Rita Biswas
  • Louis R. Piccotti
  • Ben Z. Schreiber

Abstract

We respecify the uncovered interest rate parity (UIP) conditions by inverting the market price of the risk (Sharpe ratio) formula. Our empirical model provides new insight indicating that violations to the UIP stem from the existence of a risk premium in the exchange rates and from observed market return differentials being a noisy statistic of the markets’ expected return differentials in our respecified model. Using an integrated macro‐micro structure framework for expected market return differentials improves our model fit and the validity of UIP.

Suggested Citation

  • Rita Biswas & Louis R. Piccotti & Ben Z. Schreiber, 2021. "Differential risk premiums and the UIP puzzle," Financial Management, Financial Management Association International, vol. 50(1), pages 139-167, March.
    • Handle: RePEc:bla:finmgt:v:50:y:2021:i:1:p:139-167
    DOI: 10.1111/fima.12314
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