What Covered Interest Parity Implies about the Theory of Uncovered Interest Parity
The literature assumes that the theory of uncovered interest parity fails because investing without cover is risky and investors are risk adverse. But covered interest parity implies that the theory can fail even when investors are risk neutral and hold when investors are risk adverse and there is a risk premium. The failure to fully appreciate the relation between uncovered interest parity and risk premiums has probably contributed to our failure to understand why UIP fails empirically.
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