for emerging markets so far received less attention. The few studies that explicitly analyze
the effect of monetary policy actions on the UIP condition document that central bank
policies indeed have implications for deviations from the UIP condition.
3.4 Risk Premium and the Uncovered Interest Parity
Within the context of testing for the UIP condition for developed economies, it is possible
to consider the existence of a premium due to exchange rate risk if investors are risk averse.
However, for emerging market economies, one has to also consider the possibility of having
a premium for default risk and another for political risk as well.18 The existence of these
additional premia can be justified by incomplete institutional reforms, weaker macroeco-
nomic fundamentals, more volatile economic conditions and shallow financial markets in
emerging markets. Hence, a priori, it is plausible to expect that emerging market assets
offer a higher and possibly time-varying premium to investors for bearing such risks.
As mentioned before, tests of the UIP condition do not involve a simple hypothesis,
but rather a joint one. Besides imposing rational expectations to arrive at an estimable
equation, one has to assume that agents are risk neutral, underlying assets are identical in
terms of liquidity, maturity, and default risks, and there exist deep financial markets and
perfect capital mobility. Therefore, the rejection of the UIP condition indicates one or more
of these assumptions fail. If the assumption of rational expectations can be retained, then
the failure of the UIP condition in the context of emerging markets can be attributable
to the failure risk neutrality and/or the failure of one or more other assumptions.19 For
example, when identical asset assumption fails, even risk-neutral investors will require a
premium for default risk.
These points together imply that it may be important to address the issue of risk
premium explicitly for emerging markets since even when agents have rational expectations
and are risk neutral, the other assumptions underlying the UIP condition are likely to be
violated given the aforementioned characteristics of these countries.
We next clarify the notion of risk premium and introduce the related literature on
18