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Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle

  • Cosmin L. Ilut

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, ex-post profitability and negative skewness of currency speculation payoffs.

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Paper provided by Duke University, Department of Economics in its series Working Papers with number 10-53.

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Length: 57
Date of creation: 2010
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Handle: RePEc:duk:dukeec:10-53
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