Differential Risk Premiums and the UIP Puzzle
46 Pages Posted: 22 Jun 2017 Last revised: 4 Mar 2019
Date Written: March 2, 2019
We jointly re-specify the relative purchasing power parity (RPPP) and uncovered interest rate parity (UIP) conditions as the (log) ratio of stochastic discount factors by inverting the market price of risk formula. Our empirical model provides new insights, which show that violations to UIP and RPPP both stem from the existence of a risk premium in exchange rates and from observed market return differentials being a noisy statistic of the markets' expected return differentials in our re-specified model. Using an integrated macro-microstructure framework for expected market return differentials improves our model fit and the validity of UIP and RPPP.
Keywords: Foreign exchange market, Uncovered interest rate parity, Risk premium, Purchasing power parity
JEL Classification: F31, G14, G15
Suggested Citation: Suggested Citation