UIP: A Partial Reconciliation from Event Studies

Abstract

We develop a model where foreign investors in domestic markets react partially to deviations from a UIP condition for long-term bonds. The model predicts that the sign between yield differentials and exchange rate movements is conditional on the source of shocks. Using event studies for identification, we test the model in a sample of 24 developed and emerging economies, finding a UIP-consistent correlation for monetary shocks, but the opposite around episodes of large market uncertainty. The model predicts that exchange rate stabilization policies, prevalent among emerging countries, weaken both correlations, which we confirm in the data.