A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle

34 Pages Posted: 3 Nov 2015

See all articles by Kuk Mo Jung

Kuk Mo Jung

Henan University

Seungduck Lee

Sungkyunkwan University

Date Written: November 2, 2015

Abstract

A new monetary theory is set out to resolve the "Uncovered Interest Parity (UIP)" Puzzle. It explores the possibility that liquidity properties of money and nominal bonds can account for the puzzle. A key concept in our model is that nominal bonds carry liquidity premia due to their medium of exchange role as either collateral or means of payment. In this framework no-arbitrage ensures a positive comovement of real return on money and nominal bonds. Thus, when inflation in one country becomes relatively lower, i.e., real return on this currency is relatively higher, its nominal bonds should also yield higher real return. We show that their nominal returns can also become higher under the economic environment where collateral pledgeability and/or liquidity of nominal bonds and/or collateralized credit based transactions are relatively bigger. Since a currency with lower inflation is expected to appreciate, the high interest currency does indeed appreciate in this case, i.e., the UIP puzzle is no longer an anomaly in our model. Our liquidity based theory can in fact help understanding many empirical observations that risk based explanations find difficult to reconcile with.

Keywords: uncovered interest parity puzzle, monetary search models, FOREX market

JEL Classification: E4, E31, E52,F31

Suggested Citation

Jung, Kuk Mo and Lee, Seungduck, A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle (November 2, 2015). Available at SSRN: https://ssrn.com/abstract=2685534

Kuk Mo Jung (Contact Author)

Henan University ( email )

85 Minglun St. Shunhe
Kaifeng, CA Henan 475001
China

Seungduck Lee

Sungkyunkwan University ( email )

110-745 Seoul
Korea

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