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A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle

Last Updated on 10 February, 2024 by Rejaul Karim

In the research paper “A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle” authored by Kuk Mo Jung and Seungduck Lee, a compelling new monetary theory is proposed to resolve the long-standing “Uncovered Interest Parity (UIP)” puzzle.

By delving into the liquidity properties of money and nominal bonds, the study presents a novel framework where nominal bonds carry liquidity premia, attributing their medium of exchange role as collateral or means of payment.

The model establishes a positive comovement of real return on money and nominal bonds through the lens of arbitrage, elucidating the relationship between inflation differentials and real returns.
The findings suggest that under an environment of greater collateral pledgeability and liquidity of nominal bonds, currencies with lower inflation are anticipated to appreciate, alleviating the anomaly of the UIP puzzle.

This liquidity-based theory not only resolves the UIP puzzle but also sheds light on empirical observations that were challenging for risk-based explanations, offering profound insights into the dynamics of the FOREX market.

Abstract Of Paper

A new monetary theory is set out to resolve the “Uncovered Interest Parity (UIP)” Puzzle. It explores the possibility that liquidity properties of money and nominal bonds can account for the puzzle. A key concept in our model is that nominal bonds carry liquidity premia due to their medium of exchange role as either collateral or means of payment. In this framework no-arbitrage ensures a positive comovement of real return on money and nominal bonds. Thus, when inflation in one country becomes relatively lower, i.e., real return on this currency is relatively higher, its nominal bonds should also yield higher real return. We show that their nominal returns can also become higher under the economic environment where collateral pledgeability and/or liquidity of nominal bonds and/or collateralized credit based transactions are relatively bigger. Since a currency with lower inflation is expected to appreciate, the high interest currency does indeed appreciate in this case, i.e., the UIP puzzle is no longer an anomaly in our model. Our liquidity based theory can in fact help understanding many empirical observations that risk based explanations find difficult to reconcile with.

Original paper – Download PDF

Here you can download the PDF and original paper of A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle.

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Author

Kuk Mo Jung
Henan University

Seungduck Lee
Sungkyunkwan University

Conclusion

The groundbreaking research presented in “A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle” by Kuk Mo Jung and Seungduck Lee propounds a compelling monetary theory that revolutionizes our understanding of the UIP puzzle.

By emphasizing the significance of the liquidity properties of money and nominal bonds, the study introduces a paradigm-shifting framework where nominal bonds carry liquidity premia, attributing their medium of exchange role as collateral or means of payment. The model adeptly illustrates the positive comovement of real return on money and nominal bonds, offering lucid insights into the effects of inflation disparities on currency appreciation and nominal returns.

As a result, the anomaly of the UIP puzzle is effectively addressed, and numerous empirical observations that were previously confounding for risk-based explanations find compelling resolution within the proposed liquidity-based theory.

This study not only advances our theoretical understanding but also contributes significantly to unraveling the intricacies of the FOREX market, offering a profound and innovative perspective on the dynamics of uncovered interest parity and monetary search models.

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FAQ

Q1: What is the main focus of the research paper “A Liquidity-Based Resolution of the Uncovered Interest Parity Puzzle” by Kuk Mo Jung and Seungduck Lee?

A1: The main focus of the research paper is to propose a novel monetary theory to resolve the long-standing “Uncovered Interest Parity (UIP)” puzzle. The study explores the liquidity properties of money and nominal bonds, introducing a framework where nominal bonds carry liquidity premia due to their medium of exchange role as collateral or means of payment.

Q2: How does the proposed model in the paper address the UIP puzzle, and what key concept does it introduce?

A2: The model addresses the UIP puzzle by emphasizing that nominal bonds carry liquidity premia due to their role as either collateral or means of payment. The key concept introduced in the model is that, in this framework, no-arbitrage ensures a positive comovement of real return on money and nominal bonds. Consequently, when inflation in one country is relatively lower, the real return on its currency is higher, and its nominal bonds yield higher real return.

Q3: What are the implications of the liquidity-based theory for understanding the relationship between inflation differentials and real returns in the FOREX market?

A3: The liquidity-based theory suggests that under an environment of greater collateral pledgeability and liquidity of nominal bonds, currencies with lower inflation are expected to appreciate. The positive comovement of real return on money and nominal bonds, as elucidated by the model, provides insights into the relationship between inflation differentials and real returns in the FOREX market.

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