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

emerging markets through the following classification: Those that decompose the interest
rate differential, i_t,_k — tf,_k, into appropriate components to account for various types of risks,
and those that investigate the risk premium through modern portfolio theory.

3.4.1 Decomposing the Interest Rate Differential and the Risk Premium

In a rational expectations-UIP setting, the risk premium on the domestic currency can be
defined as the expected excess return above the UIP-implied level, as:

^ρt = (it,k ^{- i}t,k) ^{- δ}k^st+k                                                                (¹¹)

where ρ_t denotes the risk premium.²⁰ In the context of developed economies, as risk-neutral
investors only care about expected returns, risk aversion is equivalent to asking for an
exchange rate risk premium. For emerging markets, however, as political and default risk
probabilities are included in expected returns, even risk-neutral investors would demand
premia for these additional risks. Therefore, ρ_t includes these risk premia both for risk-
neutral and risk-averse investors and also exchange rate risk premium if investors are risk
averse. Accordingly, lumping all these risks together within a single term and analyzing
how this term behaves over time may not be a suitable methodology for cases where these
premia are not highly positively correlated.

In line with this criticism, the interest rate differential in equation (11) can be augmented
through acknowledging that investors in question, in fact, have the option of choosing among
four alternatives instead of two, i.e. a domestic asset denominated in domestic currency
(it,k), a domestic asset denominated in foreign currency under domestic jurisdiction (i_t^f_,k),
a domestic asset denominated in foreign currency under foreign jurisdiction (i_t^E_,k^B), and a
foreign asset denominated in foreign currency (it,_k,).²1 Hence, the interest rate differential
in equation (11) can be rewritten as:

it,k ^- itt,k = (it,k ^- i^f,k) + i^ft,_k ^- it,k)

= (it,k ^- i^f,k´ + (ⁱEB ^{- i}t,k´ + (^if,k ^{- i}EB´                               (¹²)

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