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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)

Suggested Citation

  • Cosmin Ilut, 2012. "Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle," American Economic Journal: Macroeconomics, American Economic Association, vol. 4(3), pages 33-65, July.
  • 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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    More about this item

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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    1. Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle (AEJ:MA 2012) in ReplicationWiki

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