Does risk premium have explanative power in the forward premium puzzle? A review of uncovered interest parity and its empirical failure.

Abstract

One of the most studied topics in international macroeconomics and international finance is the empirical failure of uncovered interest parity condition which has come to be recognized as a stylized fact. In this paper I provide a brief review of interest parity theory and the so called forward premium puzzle. I have a closer look at the branch of literature that attempts to explain the puzzle with time-varying risk premia. Based on recent contributions to literature I investigate the validity of the risk premium approach and argue that time-varying risk premium explains part of the forward premium puzzle and, thus, should be taken into consideration in applications of uncovered interest parity.

The purpose of this work is not to contribute to existing literature but rather to provide a brief introduction to the topic and summarize the most convincing argumentation for the role of risk premium in the puzzle.