assets are not close substitutes, since their nominal returns diverge in a persistent way.
His findings suggest that the risk premia for all countries but Estonia and Lithuania are
either non-stationary or stationary with a non-declining trend. In addition, the estimated
volatilities of risk premia for these economies are found to be relatively high throughout the
sample period, which can be an evidence against the UIP condition.25
3.4.2 Asset Pricing Models and Risk Premium
Previous literature regards the expected excess return over the UIP-implied level as a pre-
mium for investors bearing risks associated with investing in an asset under different cur-
rency of denomination or jurisdiction. In the context of the capital asset pricing model
(CAPM), however, only the “systematic” portion of expected excess return is regarded as
a risk premium. In other words, an asset or portfolio having an excess return can be inter-
preted as offering a risk premium to the extent that the aforementioned risks, i.e. currency
or country risks, cannot be diversified by holding a well-diversified portfolio of assets that
includes it. The CAPM, then, can be used to extract the systematic portion of excess
currency returns. Loosely speaking, if the systematic risk is significant, the treatment of
excess returns as risk premia, as in the previous section, may be justified.26
There exists a vast number of studies testing various versions of the CAPM for emerging
markets, yet all confined to equity markets.27 Given that a country’s equities and bonds
share common dynamics of risks in the international setting, equity-market related risk
measurements can shed light on risks related to investing in fixed-income securities. Hence-
forth, we present studies on the CAPM which are explicitly related to the UIP framework
for emerging market economies, i.e. Bansal and Dahlquist (2000), Francis et al. (2002) and
Tai (2003).
Following the cross-sectional approach of Fama and Macbeth (1973), Bansal and Dahlquist
(2000) conduct a single-factor asset pricing test together with various country-specific at-
tributes for 34 developed and emerging market currency returns within the UIP context.
They investigate whether excess currency returns can be attributable to systematic risk and
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