DP16244 Five Facts about the UIP Premium

Author(s): Sebnem Kalemli-Özcan, Liliana Varela
Publication Date: June 2021
Date Revised: May 2022
Keyword(s): Excess return, Expectations, Fama regression, Policy Credibility, risk premia
JEL(s): F21, F32, F41
Programme Areas: International Macroeconomics and Finance, Macroeconomics and Growth
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=16244

We document five novel facts about Uncovered Interest Parity (UIP) deviations vis-à-vis the U.S. dollar for 34 currencies, during 1996-2018. 1) The UIP premium co-moves with global risk perception (VIX) for all currencies, whereas only for emerging market currencies there is a negative comovement between the UIP premium and capital inflows. 2) The comovement of the UIP premium and the VIX is explained by changes in interest rate differentials in emerging markets, and by changes in exchange rates in advanced countries. 3) Time-varying country risk measured by the degree of policy uncertainty can explain both the negative comovement of the UIP premium with capital inflows and the positive comovement of the UIP premium with the interest rate differentials in emerging markets. 4) While we find no overshooting and predictability reversal puzzles for any currency and no Fama puzzle in advanced economies, in emerging markets UIP never holds, on average or over time. 5) Measuring the exchange rate movements with realized vs. expected changes from survey data only matters for results on advanced countries and not for emerging markets. This is because UIP risk premium and deviations from full information rational expectations are linked to each other in emerging markets. Global investors charge an "excess risk" premium that is endogenous to policy uncertainty that affects the formation of investors' expectations of exchange rate fluctuations.