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

1 Introduction

The uncovered interest parity (UIP) condition, a cornerstone in assessing foreign exchange
market efficiency, has confronted a vast number of empirical tests which have produced
unfavorable results until recently.¹ The UIP condition is a no-arbitrage condition between
investing in a domestic currency denominated asset and a foreign currency denominated
asset such that

S^e

(1 + it,k) = (1 + it,k) -+ÿ-                                                             (1)

where i_t,_k and i↑_k are the interest rates on domestic and foreign currency denominated
assets with k periods to maturity respectively, St denotes the nominal exchange rate as
the domestic currency value of one unit of foreign currency at time t, and S_t^e_+k denotes
the current market expectation of the nominal exchange rate of t + k given all available
information at t.

A proper documentation of the assumptions underlying this equation is crucial in in-
terpreting the empirical evidence on the UIP condition. These assumptions can be stated
as follows: investors are risk neutral; transaction costs are negligible; underlying assets are
identical in terms of liquidity, maturity and default risk; and there is a sufficient number of
investors with ample funds available for arbitrage.

Previous empirical literature reaches an estimable UIP condition by log-approximation
of equation (1) and imposing rational expectations:²

^∆kst+k = it,k ^- it,_k   where   ^∆kst+k = st+k ^- st.                                   (2)

The UIP condition, hence, can be assessed empirically through estimating

^∆kst+k = ^β0 + ^β 1(it,k ^{- i}t,k) ⁺ ut+k                                                  (^3a)

and testing the joint hypothesis of β0 = 0, β1 = 1, and u_t+k is orthogonal to the information
available at t. In addition, assuming the covered interest parity (CIP) condition, i.e. f_t^k -

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