The Risk Adjusted Interest Parity: Theory and Evidence

This paper explores and tests the risk adjusted interest parity model to investigate a degree of capital mobility between the developed and Asia emerging markets in 1994.1.1-2008.7. The uncovered interest parity is revised to take into account of market risk in a framework of a portfolio rebalancing model. Evidence was found to strongly support our hypotheses; market risk is significant in capital flows between the Asian emerging and the developed markets, and it can help explain the failure of a traditional uncovered interest parity model. The relationship between returns and an appreciation of the exchange rate are divided between the Asia and developed markets, depending on the directions of capital flows.