The uncovered return parity condition

Abstract

This paper proposes an equilibrium relationship between expected exchange rate changes and differentials in expected returns on risky assets. We show that when expected returns on a risky asset in a certain economy are higher than the returns that are expected from investing in a risky asset in another economy, then the currency corresponding to the economy whose asset offers higher returns is expected to depreciate. Due to its similarity with Uncovered Interest Parity (UIP), we call this equilibrium condition “Uncovered Return Parity” (URP). However, in the URP condition returns’ differentials are not known ex ante, while in the UIP they are. The paper finds empirical support in favour of URP for certain markets over some sample periods. JEL Classification: F30, F31, G12, C32GMM, stochastic discount factor, Uncovered interest parity, Uncovered Return Parity