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

st = it,k — i↑_k, where f^k denotes the k-period forward exchange rate at t, one can test for
the UIP condition through estimating

∆_ks_t+k = β0 + β1 (f_t^k - s_t) + u_t+k                                                 (3b)

and testing the same hypothesis as above.³

Earlier empirical literature on the UIP condition mostly focuses on developed economies
rather than emerging markets because of lack of data. Recently, increases in the degree of
financial liberalization in emerging markets enabled many researchers to analyze foreign
exchange market efficiency in these economies. It is the lack of a comprehensive survey
reviewing this recent literature that motivates this study.

Briefly, our reading of the literature highlights the following points: For developed
economies, the recent literature on the UIP condition benefitting from the recent advances
in time-series econometrics provides favorable results. This literature suggests that the UIP
puzzle documented by the previous studies can in fact be a statistical artifact. For emerging
markets, the empirical literature on the UIP condition reveals that these countries indeed
deserve a special treatment due to emerging-market-specific macroeconomic conditions in-
cluding incomplete institutional reforms, weaker macroeconomic fundamentals, and shallow
financial markets. The conditions that merit special treatment while testing for the UIP
condition for emerging markets are the existence of additional types of risk premia, peso
problem, simultaneity problem, financial contagion, high inflation episodes, asymmetricity,
and the determination of de facto structural breaks, to name a few. We will focus on these
points in the text.

The rest of the paper proceeds as follows: The next section provides a general under-
standing of the UIP condition through examining the literature on developed economies,
Section 3 presents the related work on emerging market economies, and Section 4 concludes.

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