to be robust to the sample choice, possible correlation of shocks among emerging markets,
but not to the choice of base currency.11
The results of the aforementioned studies, therefore, indicate that it is possible to dif-
ferentiate emerging markets and developed economies in terms of testing for UIP. Hence,
emerging markets merit a special treatment in this respect.
The UIP literature on emerging markets differs from that on developed economies due
to emerging market specific conditions, which shape how we classify the related literature.
In particular, first, compared to developed economies, the presence of relatively volatile
economic conditions and the ongoing structural changes in emerging markets emphasize
regime-change analysis. Second, the peso problem, namely, the anticipated but not ma-
terialized changes in the exchange rate resulting in systematic deviations from the UIP
condition is expected to be mostly confined to emerging markets, as this phenomenon may
be intensified under severe structural changes. Third, monetary authorities in countries
that suffer from “fear of floating” are inclined to overstabilize the exchange rate move-
ments. Hence this makes simultaneity bias more pronounced for emerging markets. Fourth,
since emerging markets are characterized by volatile economic conditions and incomplete
institutional reforms, it is more plausible to expect risk premia offered by these country
assets. The rest of this section presents a detailed analysis of each of these points.12
3.1 Structural Changes and the Uncovered Interest Parity
The existence of relatively frequent structural breaks in emerging markets constitute the
first difference between these and the developed economies within the context of testing for
the UIP condition. In this regard, it is of crucial importance to identify the de facto break
date appropriately, since imposing a de jure structural break date and testing for the UIP
condition before and after that date may yield misleading results.13
As foreign exchange markets are liberalized, excess returns over the UIP-implied level
are expected to decay gradually both in magnitude and volatility. Using de jure financial
liberalization dates for nine emerging market economies, Francis et al. (2002) document
12