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

Question

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

Quizplus · Accepted Answer

Xt represents the risk premium. The interest rate differential and the expected change in the exchange rate only account for rational factors affecting exchange rates, so any difference in the actual exchange rate can be explained by irrational, unpredictable factors - the risk premium.