Time-varying international diversification and the forward premium

•Infinite horizon dynamic stochastic general equilibrium model with incomplete markets.•Reproduces the slope of the uncovered interest rate parity for ten country pairs.•Matches the first two moments for FX returns, inflation and income growth.•Accounts for the disconnect between consumption and FX (Backus and Smith puzzle).•Deducts plausible habit levels across different countries.

This paper reproduces the slope of the uncovered interest rate parity (UIP) regression for ten country pairs within one standard deviation under rational expectations. We propose an infinite horizon dynamic stochastic general equilibrium model with incomplete markets. Heterogeneous investors experience varying risk aversion as a result of habit formation.The underlying mechanism of the model relies on varying international diversification in the investors' portfolio choice decision. In response to their changing habit levels, investors' hedging desire varies over time. This leads to adjustments in interest rates. The habit-induced investment decisions are negatively correlated with movements in the exchange rate. This results in a negative correlation between interest rates and expected exchange rates, as implied by a negative UIP slope.Depending on the magnitude of habits, the model is capable of reproducing positive as well as negative UIP slopes, as seen empirically in the data.