UIRPUncovered Interest Rate Parity
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Interestingly, Bansal and Dahlquist also find that when there is deviation from UIRP for lower-income industrialized economies it is not caused by the existence of a risk premium.
In light of a long history of vacillation in the policy towards capital flows (see, e.g., Beim and Calomiris (2001)) and the above-mentioned debate about the appropriate response to recent currency crises, this risk should be greater in the developing economies and should give rise to significant deviations from UIRP, especially in the pre-liberalization period.
In the first stage we examine if UIRP holds for our sample of emerging markets.
We find that, in general, deviation from UIRP in emerging markets is systematic in nature and that a significant part of emerging market currency excess returns is attributable to time-varying risk premium.
My result shows that this insight is valid for default-free swaps only if UIRP holds in both domestic and foreign markets.
Note that the two terms in braces in Equation (22) are the domestic and foreign UIRP relations.
If deviations from UIRP in both markets are positive, T[Delta]V will be positive and strictly increasing in e*, but limited by the risk-free borrowing potential of the parties.
If deviations from UIRP in both markets are negative, T[Delta]V will always be negative.
Firstly, from (6), the size and sign of [delta]V[sub.0] is not uniquely determined by a possible UIRP violation, unless cash flows and SPP violations are independent, since it also depends on the covariance term (the second term).
Thus, "home country" ownership of a "host country" project would require either a strong negative violation of UIRP (E(h)<0) and/or negative covariances of cash flows with SPP violations, the latter being the exclusive condition if the UIRP held strictly (E(h)=0).
Condition (15a) is easy to interpret: Riskless foreign debt can be a part of capital structure only if there is a violation of uncovered interest parity (UIRP).
The point in this case is that the strength of the UIRP violation may undermien sufficient conditions for an international capital structure.