Insured uncovered interest parity

- Uncovered interest parity (UIP) does not hold because of sovereign credit risk.
- We examine an insured uncovered interest parity relationship using credit default swap (CDS) contracts.
- CDS rates help explain the UIP puzzle.
- CDS rates have no predictive power for carry trade and currency returns.

The current literature suggests that uncovered interest parity (UIP) does not hold because of differences in risk in holding different currency denominated debt. We test whether this risk is related to sovereign credit risk in government bonds. We consider an insured uncovered interest parity relationship - that is, one where debt is insured with credit default swap (CDS) contracts. CDS rates help explain the UIP puzzle but have no predictive power for carry trade returns and currency movements.