Examining the interest rate parity condition in a dollarized economy

This paper examines the violation of the interest rate parity condition in a dollarized economy, using the Peruvian case during the 1990s as a reference. Based on a micro-founded dynamic CAPM-Consumption model, the study argues that uncertainty and risk aversion can generate persistent differentials between the returns on assets denominated in local and foreign currency. The empirical evidence, based on deposit rates in soles and dollars for horizons of 1, 3, 6, and 12 months between 1992 and 2000, shows that average deviations from parity were negative, systematically favoring dollar deposits. Using nonparametric bootstrapping tests, the study confirms that these differentials are not due to sampling biases and that the relative profitability of foreign-currency assets helped explain the high degree of financial dollarization observed in Peru.