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

The first term in parentheses, it,k - i_t^f_,k , comprises of two identical assets in terms of
jurisdiction. This term, which can be named as currency premium, reflects only the risks
associated with exchange rate movements, as the assets differ only in terms of currency of
denomination. The second term, iEB — it_k, includes two assets under the same currency
and jurisdiction. This term is named as default risk premium, as the assets differ only in
terms of the issuer country. The third term, i_t^f_,k — i_t^E_,k^B, comprises of two assets that are
identical in terms of issuer and currency but differ in their jurisdictions. This term is called
political risk premium since the difference between the yields of these assets reflects the cost
of shifting them across jurisdictions. The summation of the last two terms, iEB — it_k and
i_t^f_,k — i_t^E_,k^B, is conventionally named as the country premium, as the assets that constitute
this premium are denominated under the same currency.²²

Accordingly, ρt in equation (11) can be augmented as

^ρt = (it,k ^- it,k) ^{- ∆}kst+k = (it,k ^- i^fk ^{- ∆}kst+k´ + (iEB ^{- i}t,k´ ⁺ (^if,k ^{- i}EB´

= ρt^E + ρt^D + ρt^P                                   (13)

where ρ_t^E denotes the exchange rate risk, ρ_t^D denotes the default risk, and ρ_t^P denotes the
political risk. Within the UIP context, we can state that ρ_t^E reflects departures from the
assumption of risk neutrality of the investors, ρ_t^D reflects departures from the assumption
of identical default risk of the assets that constitute the interest differential, and ρ_t^P reflects
the departures from the assumption of perfect mobility of assets across jurisdictions.

Data availability is a major problem in analyzing different components of risk premium
for emerging market assets. For example, it might be difficult for an emerging market econ-
omy to borrow in her own currency for long maturities. Therefore, if such a country would
like to increase the average maturity of her debt stock, she would have to borrow in terms
of foreign currency. This implies potential maturity mismatch problems when calculating
ρ_t^E and ρ_t^P .²³ To the extent that data availability problems can be remedied, several studies
analyze different components of risk premium for emerging market assets. This literature
can be classified as those that decompose the interest rate differential to analyze currency

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