Can time-varying risk premiums explain the excess returns in the interest rate parity condition?

Abstract

This paper shows that the deviations from the UIP condition are equally large in advanced and emerging market economies. Using monthly data, and a GARCH-M model we find that a large share of these deviations in both country groups are explained by time-varying risk premium. To more clearly identify risk premium shocks, we then estimate a two-country, New Keynesian, DSGE model using a Bayesian methodology and quarterly data. The results suggest that at the quarterly frequency, the large deviations from the UIP condition and the high explanatory power of risk premium are only observed for emerging market economies.