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Ambiguity Aversion: Implications For The Uncovered Interest Rate Parity Puzzle

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  • COSMIN ILUT

    (NORTHWESTERN UNIVERSITY)

Abstract

positive domestic interest rate differential predicts that the domestic currency will appreciate in the future. The reason capital inflows into high-interest-rate currencies are limited in the model is that agents tend to overstate the probability of a future depreciation. I show that my result cannot be duplicated in a simple model with risk aversion. In addition to providing a resolution to the UIP puzzle, the model predicts, consistent with the data, negative skewness and excess kurtosis for carry trade payoffs and positive average payoffs even for hedged positions.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 328.

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Date of creation: 2009
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Handle: RePEc:red:sed009:328

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  1. Bacchetta, Philippe & Mertens, Elmar & van Wincoop, Eric, 2009. "Predictability in financial markets: What do survey expectations tell us?," Journal of International Money and Finance, Elsevier, vol. 28(3), pages 406-426, April.
  2. Tomasz Strzalecki, 2011. "Axiomatic Foundations of Multiplier Preferences," Econometrica, Econometric Society, vol. 79(1), pages 47-73, 01.
  3. Emmanuel Farhi & Xavier Gabaix, 2008. "Rare Disasters and Exchange Rates," NBER Working Papers 13805, National Bureau of Economic Research, Inc.
  4. Francois Gourio, 2008. "Disasters and Recoveries," American Economic Review, American Economic Association, vol. 98(2), pages 68-73, May.
  5. Larry G. Epstein & Martin Schneider, 2007. "Learning Under Ambiguity," Review of Economic Studies, Oxford University Press, vol. 74(4), pages 1275-1303.
  6. 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.
  7. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
  8. 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.
  9. 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.
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Cited by:
  1. Jorda, Oscar, 2010. "Carry Trade," Working Papers 10-18, University of California at Davis, Department of Economics.
  2. Francis Breedon & Dagfinn Rime & Paolo Vital, 2010. "A Transaction Data Study of the Forward Bias Puzzle," Working Paper 2010/26, Norges Bank.
  3. 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.
  4. Massimo Guidolin & Francesca Rinaldi, 2011. "Ambiguity in Asset Pricing and Portfolio Choice: A Review of the Literature," Working Papers 417, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  5. Òscar Jordà & Alan M. Taylor, 2009. "The Carry Trade and Fundamentals: Nothing to Fear But FEER Itself," NBER Working Papers 15518, National Bureau of Economic Research, Inc.
  6. Charles Engel, 2011. "The Real Exchange Rate, Real Interest Rates, and the Risk Premium," Working Papers 272011, Hong Kong Institute for Monetary Research.
  7. 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.
  8. Travis Berge & Òscar Jordà & Alan M. Taylor, 2010. "Currency Carry Trades," NBER Chapters, in: NBER International Seminar on Macroeconomics 2010, pages 357-387 National Bureau of Economic Research, Inc.

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