The Economics of Uncovered Interest Parity Condition for Emerging Markets: A Survey



found to be fluctuating within a narrower margin around a level closer to zero, as the country
takes a step for liberalization, and political and macroeconomic stability is assured.15

To sum up, although the existence of relatively frequent structural breaks in emerging
markets calls for identifying break dates appropriately, the UIP literature on emerging
markets so far seems to have understudied this phenomenon. Accordingly, identifying and
modeling structural breaks provide a room for improvement for further research on the UIP
condition for emerging markets.

3.2 The Peso Problem and the Uncovered Interest Parity

Another difference between the emerging markets and the developed economies within the
context of UIP testing is that the peso problem is expected to be more pronounced for the
emerging markets. In particular, when a market expects a discrete change in the exchange
rate which is not materialized at that extent for a prolonged period, namely in the presence
of the peso problem, deviations from the UIP condition may occur through the following
mechanism: when market expectations about the future value of the exchange rate are not
fulfilled for a prolonged period, the realized value of the exchange rates deviates from the
expected exchange rate systematically. Since market expectations are reflected in the for-
ward premium, this persistent deviation causes forward premium to be a biased predictor of
the future exchange rate (Lewis, 1995). Next, by following Lewis, we demonstrate formally
how the peso problem causes such a bias in empirical UIP analyses.

The expected future exchange rate depends on whether and to what extent the current
and expected future fundamentals are compatible with the path of the exchange rate. The
path of fundamentals are affected by current and future macroeconomic policies. This can
motivate the following decomposition of the expected exchange rate of
t + 1 formed at t
into two parts:

Etst+1 =ptEt(st+1|B)+(1-pt)Et(st+1|A)                                         (7)

where A and B denote two different economic states driven by different policy choices, and

14



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