Has Uncovered Interest Parity been resolved?
For a long time it was wondered whether excess returns were available from investing in the higher nominal interest rate albeit riskier currencies. After all, what was truly the population rather than the sample risk? Perhaps this is the closest we will come to answering those questions:
We document five novel facts about Uncovered Interest Parity (UIP) deviations vis-à-vis the U.S. dollar for 34 currencies of advanced economies and emerging markets. First, the UIP premium co-moves with global risk aversion (VIX) for all currencies, whereas only for emerging market currencies there is a negative comovement between the UIP premium and capital inflows. Second, the comovement of the UIP premium and the VIX is explained by changes in interest rate differentials in emerging markets, and by expected changes in exchange rates in advanced countries. Third, 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 VIX going through interest rate differentials in emerging markets. Fourth, there are no overshooting and predictability reversal puzzles—for any currency—when using exchange rate expectations to calculate the UIP premium. Fifth, the classical Fama puzzle disappears in advanced economies in expectations, but it remains for emerging markets. As a result, while global investors expect zero excess returns and earn positive returns in the short-run and negative returns in the long-run by investing in advanced country currencies, the same global investors always expect and earn positive excess returns from emerging market currencies. These results imply that in advanced countries the UIP premium is largely due to deviations from rational expectations and full information, whereas in emerging markets, the UIP premium is a risk premium. Global investors charge an “excess” premium to compensate for policy uncertainty in emerging markets —a premium that is over and above the expected and actual depreciation of these currencies.
That is from a new NBER working paper by Ṣebnem Kalemli-Özcan and Liliana Varela.