Does Risk Premium Help Uncover the Uncovered Interest Parity Failure?

Abstract There is a general consensus emerging that the uncovered interest parity (UIP) does not hold or ex-post exchange rate change predicts the interest rate differential in the wrong direction. This paper provides a pioneer study to offer a risk premium based solution to the popular UIP failure using a dataset of 44 advanced and emerging currencies. We report that in the absence of risk premium, UIP failure is more prominent in emerging countries relative to advanced countries since only 34% of the total beta coefficients range between 0.5 and 1.5. Next, we include the risk premium in the main UIP equation using a component generalized autoregressive conditional heteroskedastic-in-mean (CGARCH-M) model and show that the results conform more to the UIP theory since 73% of the beta coefficients range between 0.5 and 1.5. Such a finding validates our argument that risk premium is the main factor responsible for UIP violation and including it in the main equation helps uncover the UIP puzzle, especially in the case of emerging countries. Overall, in the presence of risk premium, in most countries, ex-post exchange rate change bear a positive relationship with the interest rate differential as UIP predicts. This is our key contribution to the literature.