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An Incomplete Markets Explanation to the UIP Puzzle

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  • Katrin Rabitsch

    (Department of Economics, Vienna University of Economics and Business)

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.

Suggested Citation

  • Katrin Rabitsch, 2014. "An Incomplete Markets Explanation to the UIP Puzzle," Department of Economics Working Papers wuwp171, Vienna University of Economics and Business, Department of Economics.
  • Handle: RePEc:wiw:wiwwuw:wuwp171
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    References listed on IDEAS

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    7. Burton Hollifield & Armir Yaron, "undated". "The Foreign Exchange Risk Premium: Real and Nominal Factors," GSIA Working Papers 2001-E13, Carnegie Mellon University, Tepper School of Business.
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    Cited by:

    1. Lorenzo Garlappi & Jack Favilukis, 2015. "The Carry Trade and UIP when Markets are Incomplete," 2015 Meeting Papers 242, Society for Economic Dynamics.

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    More about this item

    Keywords

    Uncovered Interest Rate Parity; Incomplete Market; Precautionary Savings; Time-Varying Risk Premium;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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