Differential Risk Premiums and the UIP Puzzle

Abstract

We jointly re-specify the relative purchasing power parity (RPPP) and uncovered interest rate parity (UIP) conditions as the (log) ratio of stochastic discount factors by inverting the market price of risk formula. Our empirical model provides new insights, which show that violations to UIP and RPPP both stem from the existence of a risk premium in exchange rates and from observed market return differentials being a noisy statistic of the markets' expected return differentials in our re-specified model. Using an integrated macro-microstructure framework for expected market return differentials improves our model fit and the validity of UIP and RPPP.