Handbook of Safeguarding Global Financial Stability

Chapter 23

Explaining Deviations from Uncovered Interest Rate Parity

P. Bacchetta

University of Lausanne, Lausanne, Switzerland

Centre for Economic Policy Research (CEPR), London, UK

Introduction

Risk Premium with Representative Investors

Limited Participation

Deviations from Rational Expectations

Conclusion

References

Introduction

A key relationship in international finance is uncovered interest rate parity (UIP). An approximated version of this relationship is

(23.1)

where s_t is the log nominal exchange rate (domestic per foreign currency), i_i and i_t* are domestic and foreign one-period nominal interest rates, and E_t is market expectation based ...