In the Interest Parity Condition, Rt - R t = ( - Et)/Et + xt, where Rt - R t 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, Rt - R  t = (  - Et)/Et + xt, where Rt - R  t 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. It is the difference between the actual interest rate differential and the expected change in the exchange rate, so it accounts for any additional risk or uncertainty in the market beyond what is predicted by the Interest Parity Condition.

In the Interest Parity Condition, Rt - R T