Asset prices with stochastic volatilities and a UIP puzzle

Abstract

In this paper, I extend the two-country general equilibrium model with smooth transition regimes in volatilities to examine the time-varying features of foreign exchange excess returns. The representative agent is assumed to have the Epstein-Zin-Weil preference, which allows the long run risks and macroeconomic uncertainties to be priced. The smooth transition in volatilities generates another route of uncertainty in macroeconomic variabilities for each country, which plays an important role in determining the behavior of changes in exchange rates and interest differentials across countries. Furthermore, I present an explanation for the failure of the uncovered interest parity condition, showing that the expected excess returns can be negatively correlated with the interest differential in the model. The results of the simulation show that if the representative agent with the Epstein-Zin-Weil utility prefers early resolution of uncertainty, the uncovered interest parity puzzle can be explained.