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Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle

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  • Cosmin Ilut

Abstract

High interest rate currencies tend to appreciate in the future relative to low interest rate currencies instead of depreciating as uncovered interest parity (UIP) predicts. I construct a model of exchange rate determination in which ambiguity-averse agents face a dynamic filtering problem featuring signals of uncertain precision. Solving a max-min problem, agents act upon a worst-case signal precision and systematically underestimate the hidden state that controls payoffs. Thus, on average, agents next periods perceive positive innovations, which generates an upward re-evaluation of the strategy's profitability and implies ex post departures from UIP. The model also produces predictable expectational errors, negative skewness, and time-series momentum for currency speculation payoffs. (JEL D81, F31, G15)

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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 4 (2012)
Issue (Month): 3 (July)
Pages: 33-65

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Handle: RePEc:aea:aejmac:v:4:y:2012:i:3:p:33-65

Note: DOI: 10.1257/mac.4.3.33
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  1. Hanno Lustig & Adrien Verdelhan, 2006. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk," Boston University - Department of Economics - Working Papers Series WP2006-045, Boston University - Department of Economics.
  2. Almuth Scholl & Harald Uhlig, 2006. "New Evidence on the Puzzles: Monetary Policy and Exchange Rates," Computing in Economics and Finance 2006 5, Society for Computational Economics.
  3. Chakraborty, Avik & Evans, George W., 2008. "Can perpetual learning explain the forward-premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 477-490, April.
  4. Francois Gourio, 2008. "Disasters and Recoveries," American Economic Review, American Economic Association, vol. 98(2), pages 68-73, May.
  5. Lucio Sarno, 2005. "Towards a Solution to the Puzzles in Exchange Rate Economics: Where Do We Stand?," Working Papers wp05-11, Warwick Business School, Finance Group.
  6. Levin, Andrew T. & Williams, John C., 2003. "Robust monetary policy with competing reference models," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 945-975, July.
  7. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Boston University - Department of Economics - Working Papers Series WP2006-047, Boston University - Department of Economics.
  8. Tomasz Strzalecki, 2011. "Axiomatic Foundations of Multiplier Preferences," Econometrica, Econometric Society, vol. 79(1), pages 47-73, 01.
  9. Bacchetta, Philippe & Mertens, Elmar & van Wincoop, Eric, 2006. "Predictability in Financial Markets: What Do Survey Expectations Tell Us?," CEPR Discussion Papers 5770, C.E.P.R. Discussion Papers.
  10. Isaac Kleshchelski & Nicolas Vincent, 2007. "Robust Equilibrium Yield Curves," Cahiers de recherche 08-02, HEC Montréal, Institut d'économie appliquée.
  11. Xavier Gabaix, 2008. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," NBER Working Papers 13724, National Bureau of Economic Research, Inc.
  12. Larry Epstein & Martin Schneider, 2006. "Learning Under Ambiguity," RCER Working Papers 527, University of Rochester - Center for Economic Research (RCER).
  13. Kaminsky, Graciela, 1993. "Is There a Peso Problem? Evidence from the Dollar/Pound Exchange Rate, 1976-1987," American Economic Review, American Economic Association, vol. 83(3), pages 450-72, June.
  14. Hanno Lustig & Adrien Verdelhan, 2004. "The Cross-Section of Foreign Currency Risk Premia and US Consumption Growth Risk," 2004 Meeting Papers 136c, Society for Economic Dynamics.
  15. Emmanuel Farhi, 2008. "Rare Disasters and Exchange Rates," 2008 Meeting Papers 47, Society for Economic Dynamics.
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Cited by:
  1. Travis J. Berge & Òscar Jordà & Alan M. Taylor, 2010. "Currency Carry Trades," NBER Working Papers 16491, National Bureau of Economic Research, Inc.
  2. Olivier Coibion & Yuriy Gorodnichenko, 2010. "Information Rigidity and the Expectations Formation Process: A Simple Framework and New Facts," NBER Working Papers 16537, National Bureau of Economic Research, Inc.
  3. Jordà, Òscar & Taylor, Alan M., 2009. "The Carry Trade and Fundamentals: Nothing to Fear But FEER Itself," CEPR Discussion Papers 7568, C.E.P.R. Discussion Papers.
  4. Breedon, Francis & Rime, Dagfinn & Vitale, Paolo, 2010. "A Transaction Data Study of the Forward Bias Puzzle," CEPR Discussion Papers 7791, C.E.P.R. Discussion Papers.
  5. Massimo Guidolin & Francesca Rinaldi, 2010. "Ambiguity in asset pricing and portfolio choice: a review of the literature," Working Papers 2010-028, Federal Reserve Bank of St. Louis.
  6. Charles Engel, 2011. "The Real Exchange Rate, Real Interest Rates, and the Risk Premium," NBER Working Papers 17116, National Bureau of Economic Research, Inc.
  7. Oscar Jorda, 2010. "Carry Trade," Working Papers 1019, University of California, Davis, Department of Economics.
  8. Adrien Verdelhan, 2012. "The Share of Systematic Variation in Bilateral Exchange Rates," 2012 Meeting Papers 763, Society for Economic Dynamics.
  9. Olivier Coibion & Yuriy Gorodnichenko, 2012. "Information Rigidity and the Expectations Formation Process," IMF Working Papers 12/296, International Monetary Fund.
  10. Martin Schneider, 2010. "The Research Agenda: Martin Schneider on Multiple Priors Preferences and Financial Markets," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 11(2), April.
  11. Charles Engel, 2013. "Exchange Rates and Interest Parity," NBER Working Papers 19336, National Bureau of Economic Research, Inc.

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