Foreign exchange market equilibrium under imperfect asset substitutability

Abstract

Uncovered Interest Rate Parity (UIP) has been almost universally rejected as being able to explain exchange rate movements. The lack of ability of UIP to explain exchange rate movements can be considered as evidence of the presence of a time varying risk premium. In this paper, I develop a risk premium model for the FX-market equilibrium based on monetary policy and on investors’ behavior. The developed model is then generalized by adding a set of variables X that could influence the risk premium. The empirical tests of the generalized model suggest that the current account, the business cycle and inflation volatility (monetary policy) play an important role in the FX-market.