Volume 31, Issue 1 (Spring 2026)
EPRJ 2026, 31(1): 45-77 |
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Jalali Naeini S A, Sharifmoghaddam E. (2026). A review of the topic of international risk sharing and interest rate parity. EPRJ. 31(1), 45-77.
URL: http://eprj.ir/article-1-2454-en.html
URL: http://eprj.ir/article-1-2454-en.html
1- Professor, Department of Economics and Systems, Institute for Management and Planning Studies (IMPS), Tehran, Iran.
2- Ph. D. Student, Faculty of Economics,Institute for Management and Planning Studies (IMPS), Tehran, Iran.(Coresponding Author)) ,Ehsan.Sharifmoghaddam@gmail.com
2- Ph. D. Student, Faculty of Economics,Institute for Management and Planning Studies (IMPS), Tehran, Iran.(Coresponding Author)) ,
Abstract: (793 Views)
This review paper examines the theoretical foundations and empirical limitations of two cornerstone assumptions in international macroeconomics: complete markets and uncovered interest parity (UIP), as derived within the standard New Keynesian Small Open Economy (NK SOE) framework. Theoretically, the assumption of complete international financial markets yields a strong risk-sharing condition, linking domestic consumption directly to world consumption and the real exchange rate. Simultaneously, allowing households to choose between domestic and foreign bonds delivers the UIP condition, which posits that interest rate differentials are entirely offset by expected nominal exchange rate depreciation. While these derivations provide a tractable and elegant benchmark, their empirical predictions systematically fail. Risk-sharing is rejected by the data as shown in the Backus-Smith puzzle; whereas UIP is consistently violated by the forward premium puzzle. Confronted with these persistent anomalies, the literature has transitioned away from the complete markets paradigm toward richer frameworks that incorporate incomplete markets, financial frictions, deviations from rational expectations, time-varying risk premiums, and pricing-to-market behavior. This survey traces that evolution, highlighting how each theoretical modification strives to reconcile the elegant micro-founded model with the unruly dynamics observed in actual exchange rates and international consumption patterns.
Keywords: complete market, international risk sharing, uncovered interest rate parity, risk premium, terms of trade, new Keynesian open small economy
Type of Study: Research |
Subject:
Macroeconomics
Received: Jun 19 2026 | Accepted: Aug 06 2026 | ePublished: Oct 05 2026
Received: Jun 19 2026 | Accepted: Aug 06 2026 | ePublished: Oct 05 2026
References
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24. Berka, Martin, Mario Crucini and Chih-Wei Wang, 2012. International risk sharing and commodity prices. Canadian Journal of Economics 45, 417-447. [DOI:10.1111/j.1540-5982.2012.01706.x]
25. Backus, D. K., & Smith, G. W. (1993). Consumption and real exchange rates in dynamic economies with non-traded goods. Journal of International Economics, 35(3-4), 297-316. [DOI:10.1016/0022-1996(93)90021-O]
26. Cociuba, S. E., & Ramanarayanan, A. (2019). International risk sharing with endogenously segmented asset markets. Journal of International Economics, *118*, 18-37. [DOI:10.1016/j.jinteco.2018.12.003]
27. Einzig, P. (1962). A Dynamic Theory of Forward Exchange. London: Macmillan. (IMF eLibrary)
28. Epstein, L. G., & Zin, S. E. (1991). Substitution, risk aversion, and the temporal behaviour of consumption and asset returns: An empirical analysis. Journal of Political Economy, 99(2), 263-286. [DOI:10.1086/261750]
29. Frankel, J. A., & Froot, K. A. (1987). Using survey data to test standard propositions regarding exchange rate expectations. American Economic Review, 77(1), 133-153. (IMF eLibrary)
30. French, K. R., & Poterba, J. M. (1991). Investor diversification and international equity markets. American Economic Review, 81(2), 222-226 [DOI:10.3386/w3609]
31. Galí, J., & Monacelli, T. (2005). Monetary policy and exchange rate volatility in a small open economy. Review of Economic Studies, 72(3), 707-734. [DOI:10.1111/j.1467-937X.2005.00349.x]
32. Gabaix, X., & Maggiori, M. (2022). Exchange Rate Theory: The Uncovered Interest Parity Puzzle and Beyond. Annual Review articles and lecture notes are also widely cited, though the 2015 QJE paper is the standard reference.
33. Hansen, L. P., & Hodrick, R. J. (1980). Forward exchange rates as optimal predictors of future spot rates: An econometric analysis. Journal of Political Economy, 88(5), 829-853. [DOI:10.1086/260910]
34. Harold L. Cole, & Maurice Obstfeld (1991). Commodity trade and international risk sharing: How much do financial markets matter? Journal of Monetary Economics, 28(1), 3-24. [DOI:10.1016/0304-3932(91)90023-H]
35. Harold L. Cole, & Timothy J. Kehoe (2000). Self-Fulfilling Debt Crises. Review of Economic Studies, 67(1), 91-116. [DOI:10.1111/1467-937X.00123]
36. Hess, G. D., & Shin, K. (1998). Risk and exchange rate expectations. Open Economies Review.
37. Ito, T. (1988). Use of (time-domain) vector autoregressions to test uncovered interest parity. (less cited than the AER paper). [DOI:10.2307/1928314]
38. Karen K. Lewis (2000). Why Do Stocks and Consumption Imply Such Different Gains from International Risk Sharing? Journal of International Economics, 52(1), 1-35. [DOI:10.1016/S0022-1996(99)00027-6]
39. Keynes, J. M. (1923). A Tract on Monetary Reform. London: Macmillan. (IMF eLibrary)
40. Linda L. Tesar, & Ingrid M. Werner (1995). Home Bias and High Turnover. Journal of International Money and Finance, 14(4), 467-492. [DOI:10.1016/0261-5606(95)00023-8]
41. Obstfeld, M., & Rogoff, K. (1995). Exchange rate dynamics redux. Journal of Political Economy, 103(3), 624-660. [DOI:10.1086/261997]
42. Obstfeld, M., & Rogoff, K. (2000). The six major puzzles in international macroeconomics: Is there a common cause? NBER Working Paper No. 7777. [DOI:10.3386/w7777]
43. Rouillard, J.-F. (2018). International risk sharing and financial shocks. Journal of International Money and Finance, *82*, 26-44. [DOI:10.1016/j.jimonfin.2017.12.005]
44. Wang, H. (2014). Limited participation and international risk sharing: Does the nominal exchange rate matter? (SSRN Working Paper No. 2412041). [DOI:10.2139/ssrn.2506728]
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