International Yield Differentials Do Not Equal Risk Premiums
Greek Economic Review, Vol. 21, No. 1, pp. 1-17, Spring 2001
27 Pages Posted: 25 Nov 2003
International risk premiums on low-credibility currencies are routinely measured by yield differences with otherwise comparable instruments issued in a hard currency. Such measures, while adequate for any permanent component of country-specific risk, are incorrect when applied during periods of currency and banking crisis in emerging markets. The reason is that such crises typically generate large risk-adjusted real interest-rate differentials that may be compensated by future movements in the real exchange rate. If riskless rates can differ because only asset markets can adjust immediately to the new outlook created by a crisis, the risk premium can not be equated with observed international yield spreads. Instead, an intertemporal UIP model serves to estimate both permanent and temporary components of currency risk premiums. The usefulness of the results obtained with this model is demonstrated by showing that the measure of the surge in currency risk obtained for the tequila crisis bids fair to explain financial and economic declines that actually occurred.
Keywords: Currency Risk, Emerging-Country Risk, Political Risk, Uncovered Interest
JEL Classification: F3, E4
Suggested Citation: Suggested Citation