going structural changes in emerging markets emphasize structural-break analysis. Second,
significant policy changes which are anticipated but not materialized for prolonged periods
are more likely to be observed for emerging markets. This point highlights the existence
of the peso problem for emerging markets. Third, due to widespread “fear of floating” of
central banks in emerging markets, monetary authorities in these countries over-react to
large swings in exchange rate movements. Such policy actions by the monetary authority
lead to the simultaneity problem, which should be taken into account while testing for the
UIP condition. Lastly, besides exchange rate risks, emerging market assets are likely to
be prone to default and political risks. Hence, while testing for the UIP condition, these
additional risks should be incorporated for emerging markets. In accordance with these
points, we classify the emerging market specific studies under four broad categories.
The first strand of literature, which focuses on structural-break analysis, reveals that
along the financial liberalization processes, in general, deviations from the UIP condition
abates. Our understanding of this literature is that in analyzing the UIP condition, struc-
tural break dates should indeed be taken into account and be endogenized. Future research
on this topic may address the difference between de jure and de facto break dates as well
as endogenous structural breaks.
With regards to the second and the third points, we identify evidence for the peso
problem and the simultaneity problem for emerging markets in the literature. The existence
of these points, as warranted (albeit by a limited number of studies), indicates that potential
unfavorable evidence for the UIP condition may not necessarily imply foreign exchange
market inefficiency for emerging markets.
The fourth strand of literature has decomposed ex post deviations from the UIP condi-
tion appropriately, and documented that besides exchange rate risks, default and political
risks, which are also reported to be related to macroeconomic fundamentals, play a role in
driving departures from the UIP condition. In practice, so far, the calculation of these dif-
ferent types of risks has not been feasible due to data unavailability as financial markets in
emerging markets are shallow and the time span is short. Over time, with the accumulation
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