An Incomplete Markets Explanation of the Uncovered Interest Rate Parity Puzzle |
| |
Authors: | Katrin Rabitsch |
| |
Affiliation: | Department of Economics, Institute for International Economics and Development, Vienna University of Economics and Business, Vienna, Austria |
| |
Abstract: | A large literature attributes failure of uncovered interest rate parity (UIP) to the existence of a time‐varying risk premium. This paper presents a mechanism in a simple two‐country two‐good endowment economy with incomplete markets that generates sizeable deviations from UIP. In a parameterization where international wealth effects are important, liquidity constraints on an internationally traded bond and agents’ strong resulting precautionary motives successfully generates a time‐varying risk premium: countries that have accumulated large outstanding external positions have, being closer to the constraints, stronger precautionary motives and their asset carries a risk premium. |
| |
Keywords: | |
|
|