In the Interest Parity Condition, R_t - R _t = ( - E_t)/E_t + x_t, where R_t - R _t is the interest rate differential and ( - E_t)/E_t is the expected change in the exchange rate, what does x_t stand for if it potentially is a market efficient difference between the two?

Question

Quizplus · Accepted Answer

x_t represents the risk premium, meaning the additional return that investors require for taking on the currency risk. If there were no risk premium, the interest rate differential and the expected change in the exchange rate would fully explain the difference in returns between the two currencies. Therefore, x_t is often used as a measure of market efficiency - if it is close to zero, the market is considered efficient. However, the fact that x_t exists suggests that investors require a higher return to compensate for the risk involved in holding one currency over the other.

In the Interest Parity Condition, Rt - R t

In the Interest Parity Condition, R_t - R _t