INTEREST-RATE PARITY AND FOREIGN-EXCHANGE RISK PREMIA IN THE ERM

In this paper we evaluate Uncovered Interest Rate Parity in the ERM by testing market efficiency and zero risk premia in a general asset pri cing framework. The overidentifying conditions derived from the model are not rejected but we strongly reject risk neutrality. Nevertheless, estimated risk premia between ERM currencies are moderate to low. The refore, due to the diversifiability of foreign exchange risk, the stan dard UIP relation between exchange rates and interest rates is a reaso nable approximation within the ERM. (JEL F31, G12, G15). Copyright (C) 1996 Elsevier Science Ltd