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Rational Inattention: A Solution to the Forward Discount Puzzle

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  • Philippe Bacchetta
  • Eric van Wincoop

Abstract

The uncovered interest rate parity equation is the cornerstone of most models in international macro. However, this equation does not hold empirically since the forward discount, or interest rate differential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle is one of the most extensively researched areas in international finance. It implies that excess returns on foreign currency investments are predictable. In this paper we propose a new explanation for this puzzle based on rational inattention. We develop a model where investors face a cost of collecting and processing information. Investors with low information processing costs trade actively, while other investors are inattentive and trade infrequently. We calibrate the model to the data and show that (i) inattention can account for most of the observed predictability of excess returns in the foreign exchange market, (ii) the benefit from frequent trading is relatively small so that few investors choose to be attentive, (iii) average expectational errors about future exchange rates are predictable in a way consistent with survey data for market participants, and (iv) the model can account for the puzzle of delayed overshooting of the exchange rate in response to interest rate shocks.

Suggested Citation

  • Philippe Bacchetta & Eric van Wincoop, 2005. "Rational Inattention: A Solution to the Forward Discount Puzzle," NBER Working Papers 11633, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:11633
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    Cited by:

    1. Frankel, Jeffrey & Poonawala, Jumana, 2010. "The forward market in emerging currencies: Less biased than in major currencies," Journal of International Money and Finance, Elsevier, vol. 29(3), pages 585-598, April.
    2. Moore, Michael J. & Roche, Maurice J., 2010. "Solving exchange rate puzzles with neither sticky prices nor trade costs," Journal of International Money and Finance, Elsevier, vol. 29(6), pages 1151-1170, October.
    3. Philippe Bacchetta & Eric Van Wincoop, 2006. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," American Economic Review, American Economic Association, vol. 96(3), pages 552-576, June.
    4. Campbell, Rachel & Koedijk, Kees & Lothian, James R & Mahieu, Ronald J, 2007. "Irving Fisher, Expectational Errors, and the UIP Puzzle," CEPR Discussion Papers 6294, C.E.P.R. Discussion Papers.
    5. Christophe Chamley, 2006. "Complementarities in information acquisition with short-term trades," Boston University - Department of Economics - Working Papers Series WP2006-042, Boston University - Department of Economics.
    6. Bluedorn, John C. & Bowdler, Christopher, 2011. "The open economy consequences of U.S. monetary policy," Journal of International Money and Finance, Elsevier, vol. 30(2), pages 309-336, March.
    7. Bluedorn, John & Bowdler, Christopher, 2006. "Open economy codependence: US monetary policy and interest rate pass-through," Discussion Paper Series In Economics And Econometrics 615, Economics Division, School of Social Sciences, University of Southampton.
    8. Scholl, Almuth & Uhlig, Harald, 2008. "New evidence on the puzzles: Results from agnostic identification on monetary policy and exchange rates," Journal of International Economics, Elsevier, vol. 76(1), pages 1-13, September.
    9. repec:bla:econom:v:84:y:2017:i:335:p:516-540 is not listed on IDEAS
    10. Bluedorn, John & Bowdler, Christopher, 2006. "Open economy codependence: US monetary policy and interest rate pass-through," Discussion Paper Series In Economics And Econometrics 0615, Economics Division, School of Social Sciences, University of Southampton.
    11. Goddard, John & Kita, Arben & Wang, Qingwei, 2015. "Investor attention and FX market volatility," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 38(C), pages 79-96.
    12. Jongen, Ron & Verschoor, Willem F C & Wolff, Christian C & Zwinkels, Remco C.J., 2008. "Dispersion of Beliefs in the Foreign Exchange Market," CEPR Discussion Papers 6738, C.E.P.R. Discussion Papers.
    13. Christian, Mueller-Kademann, 2009. "Puzzle solver," MPRA Paper 19852, University Library of Munich, Germany.
    14. Steve Furnagiev & Josh Stillwagon, 2015. "Subjective Currency Risk Premia and Deviations from Moving Averages," Working Papers 1506, Trinity College, Department of Economics.
    15. Waheed, Muhammad, 2009. "Forward rate unbiased hypothesis, risk premium and exchange rate expectations: estimates on Pakistan Rupee-US Dollar," MPRA Paper 33167, University Library of Munich, Germany, revised Jul 2010.
    16. Craighead, William D. & Davis, George K. & Miller, Norman C., 2010. "Interest differentials and extreme support for uncovered interest rate parity," International Review of Economics & Finance, Elsevier, vol. 19(4), pages 723-732, October.
    17. Müller, Christian, 2012. "A new interpretation of known facts: The case of two-way causality between trading and volatility," Economic Modelling, Elsevier, vol. 29(3), pages 664-670.
    18. De Paoli, Bianca & Sondergaard, Jens, 2009. "Foreign exchange rate risk in a small open economy," Bank of England working papers 365, Bank of England.
    19. Loring, Grace & Lucey, Brian, 2013. "An analysis of forward exchange rate biasedness across developed and developing country currencies: Do observed patterns persist out of sample?," Emerging Markets Review, Elsevier, vol. 17(C), pages 14-28.

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    JEL classification:

    • F3 - International Economics - - International Finance
    • G1 - Financial Economics - - General Financial Markets
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates

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