in the wrong direction. Yet, recent studies show that the problem is mostly confined to the
mid-horizon investments only. Employing methodological advances, recent literature reveal
that the puzzle may in fact be a statistical artifact, i.e. ignoring structural breaks, confining
the UIP estimation to a linear framework, and ignoring high persistence in the data may
lead to spuriously unfavorable results within the context of the UIP condition.
3 Uncovered Interest Parity and Emerging Market Economies
Many emerging markets have begun liberalizing their financial accounts in the late 1980s
and the early 1990s, as seen in Table 1.7 However, their degrees of financial liberaliza-
tion are still by and large less than those observed in developed economies.8 Emerging
market economies are mostly characterized by incomplete institutional reforms, relatively
volatile economic conditions, weaker macroeconomic fundamentals and shallow financial
markets. Since the UIP condition holds under the assumptions of perfect capital mobility,
risk neutrality, identical assets in terms of liquidity, maturity and default risk, and negligi-
ble transaction costs, each of these characteristics, then, may contribute to deviations from
the UIP condition for these economies. Loosely speaking, incomplete institutional reforms
may contribute to higher default risks and positive transaction costs, whereas relatively
volatile economic conditions and weaker macroeconomic fundamentals may contribute to
higher currency and default risks both in magnitude and volatility. In light of these, it is
plausible to expect that the UIP condition is less likely to hold in emerging markets than
in developed economies.
We first survey the comparative empirical literature on developed and emerging market
economies within the context of the UIP. This strand of literature attempts to shed light
on whether emerging markets and developed economies should be differentiated within
the context of UIP estimations. After underlining these differences, we provide a detailed
discussion for each item.
Bansal and Dahlquist (2000), Flood and Rose (2002) and Frankel and Poonawala (2006)
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