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The Failure of Uncovered Interest Parity: Is it Near-rationality in the Foreign Exchange Market?

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  • David W.R. Gruen

    (Reserve Bank of Australia)

  • Gordon D. Menzies

    (Reserve Bank of Australia)

Abstract

A risk-averse US investor adjusts the shares of a portfolio of short-term nominal domestic and foreign assets to maximize expected utility. The optimal strategy is to respond immediately to all new information which arrives weekly. We calculate the expected utility foregone when the investor abandons the optimal strategy and instead optimizes less frequently. We also consider the cases where the investor ignores the covariance between returns sourced in different countries, and where the investor makes unsystematic mistakes when forming expectations of exchange rate changes. We demonstrate that the expected utility cost of sub-optimal behaviour is generally very small. Thus, for example, if investors adjust portfolio shares every three months, they incur an average expected utility loss equivalent to about 0.16% p.a. It is therefore plausible that slight opportunity costs of frequent optimization may outweigh the benefits. This result may help explain the failure of uncovered interest parity.

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Bibliographic Info

Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9103.

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Date of creation: May 1991
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Handle: RePEc:rba:rbardp:rdp9103

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  1. Baillie, Richard T & Bollerslev, Tim, 2002. "The Message in Daily Exchange Rates: A Conditional-Variance Tale," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 60-68, January.
  2. Akerlof, George A & Yellen, Janet L, 1985. "Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?," American Economic Review, American Economic Association, vol. 75(4), pages 708-20, September.
  3. Jeffrey A. Frankel & Richard Meese, 1987. "Are Exchange Rates Excessively Variable?," NBER Working Papers 2249, National Bureau of Economic Research, Inc.
  4. Jeffrey A. Frankel & Kenneth A. Froot, 1985. "Using Survey Data to Test Some Standard Propositions Regarding Exchange Rate Expectations," NBER Working Papers 1672, National Bureau of Economic Research, Inc.
  5. Cecchetti, Stephen G & Mark, Nelson C, 1990. "Evaluating Empirical Tests of Asset Pricing Models: Alternative Interpretations," American Economic Review, American Economic Association, vol. 80(2), pages 48-51, May.
  6. Baldwin, Richard, 1990. "Re-Interpreting the Failure of Foreign Exchange Market Efficiency Tests: Small Transaction Costs, Big Hysteresis Bands," CEPR Discussion Papers 407, C.E.P.R. Discussion Papers.
  7. Jeffrey A. Frankel & Charles Engel, 1982. "Do Asset-Demand Functions Optimize over the Mean and Variance of Real Returns? A Six-Currency Test," NBER Working Papers 1051, National Bureau of Economic Research, Inc.
  8. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-92, Summer.
  9. Cumby, Robert E., 1988. "Is it risk? : Explaining deviations from uncovered interest parity," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 279-299, September.
  10. Frankel, Jeffrey A & Froot, Kenneth A, 1987. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," American Economic Review, American Economic Association, vol. 77(1), pages 133-53, March.
  11. Jeffrey A. Frankel, 1987. "Recent Estimates of Time-Variation in the Conditional Variance and in the Exchange Risk Premium," NBER Working Papers 2367, National Bureau of Economic Research, Inc.
  12. Goodhart, Charles, 1988. "The Foreign Exchange Market: A Random Walk with a Dragging Anchor," Economica, London School of Economics and Political Science, vol. 55(220), pages 437-60, November.
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Cited by:
  1. Guests, R.S. & McDonald, I.M., 1996. "The Socially Optimal Level of Saving in Australia, 1960-61 to 1994-95," Department of Economics - Working Papers Series 526, The University of Melbourne.

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