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Abstract

In this paper we develop a model of uncovered interest-rate parity that assumes risk adverse individuals and takes into account not only the expected interest rate but also exchange-rate risk and the liquidity premium. We estimate the model after the opening of Israel’s economy to capital flows, and show that as a long-term relationship, there is parity between the uncovered interest rate spread and the expectations on the change of the exchange rate as derived from the ‘long-term’ equilibrium relationship of relative purchasing power parity. The interest-rate differential between Israel and the US is also affected by changes in exchange-rate risks, as measured by the standard deviation of dollar options, and by a liquidity premium. In the period of disinflation––up to 2000––the effect of the expected change in the exchange rate on the interest-rate differential was dominant. From 2000 the contribution of the variables that measure the liquidity premium and the exchange-rate-risk premium are the dominant ones in the explanation of the development of the interest-rate differential. Deviations of the interest rate from that derived from the long-term equilibrium apparently lead to a reaction from the Bank of Israel, caused by the pass-through between these deviations and the changes in the exchange rate, that in turn cause deviations in inflation expectations. The process of converging to the long term is estimated to take about eight months.

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