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Rethinking Deviations from Uncovered Interest Parity: The Role of Covariance Risk and Noise

  • Nelson Mark

    ()

  • Yangru Wu

The authors examine the ability of the standard intertemporal asset pricing model and a model of noise trading to explain why the forward foreign exchange premium predicts the future currency depreciation with the 'wrong' sign. They find that the intertemporal asset pricing model is unable to predict risk premia with the correct sign to be consistent with the data. The noise-trader model, while highly stylized, receives fragmentary support from empirical research on survey expectations.

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Paper provided by Ohio State University, Department of Economics in its series Working Papers with number 98-05.

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Date of creation: Mar 1998
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Handle: RePEc:osu:osuewp:98-05
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  1. Hai, Weike & Mark, Nelson C & Wu, Yangru, 1997. "Understanding Spot and Forward Exchange Rate Regressions," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 12(6), pages 715-34, Nov.-Dec..
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  5. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
  6. Evans, Martin D. D. & Lewis, Karen K., 1993. "Trends in excess returns in currency and bond markets," European Economic Review, Elsevier, vol. 37(5), pages 1005-1019, June.
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  8. Baillie, Richard T & Bollerslev, Tim, 1989. "The Message in Daily Exchange Rates: A Conditional-Variance Tale," Journal of Business & Economic Statistics, American Statistical Association, vol. 7(3), pages 297-305, July.
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  10. Chen, Jian & Mark, Nelson C, 1996. "Alternative Long-Horizon Exchange-Rate Predictors," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 1(4), pages 229-50, October.
  11. David Backus & Silverio Foresi & Chris Telmer, 1994. "The Forward Premium Anamoly: Three Examples in Search of a Solution," GSIA Working Papers 7, Carnegie Mellon University, Tepper School of Business.
  12. Eichengreen, Barry & Tobin, James & Wyplosz, Charles, 1995. "Two Cases for Sand in the Wheels of International Finance," Economic Journal, Royal Economic Society, vol. 105(428), pages 162-72, January.
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  15. Kandel, Shmuel & Stambaugh, Robert F, 1990. "Expectations and Volatility of Consumption and Asset Returns," Review of Financial Studies, Society for Financial Studies, vol. 3(2), pages 207-32.
  16. Mark, Nelson C. & Choi, Doo-Yull, 1997. "Real exchange-rate prediction over long horizons," Journal of International Economics, Elsevier, vol. 43(1-2), pages 29-60, August.
  17. Breuer, Janice Boucher & Wohar, Mark E, 1996. "The Road Less Travelled: Institutional Aspects of Data and Their Influence on Empirical Estimates with an Application to Tests of Forward Rate Unbiasedness," Economic Journal, Royal Economic Society, vol. 106(434), pages 26-38, January.
  18. Bekaert, Geert, 1994. "Exchange rate volatility and deviations from unbiasedness in a cash-in-advance model," Journal of International Economics, Elsevier, vol. 36(1-2), pages 29-52, February.
  19. Blake LeBaron, . "Do Moving Average Trading Rule Results Imply Nonlinearities in Foreign Exchange?," Working papers _005, University of Wisconsin - Madison.
  20. Cecchetti, Stephen G & Lam, Pok-sang & Mark, Nelson C, 1994. " Testing Volatility Restrictions on Intertemporal Marginal Rates of Substitution Implied by Euler Equations and Asset Returns," Journal of Finance, American Finance Association, vol. 49(1), pages 123-52, March.
  21. Chinn, Menzie D. & Meese, Richard A., 1995. "Banking on currency forecasts: How predictable is change in money?," Journal of International Economics, Elsevier, vol. 38(1-2), pages 161-178, February.
  22. Canova, Fabio & Ito, Takatoshi, 1991. "The Time-Series Properties of the Risk Premium in the Yen/Dollar Exchange Market," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 6(2), pages 125-42, April-Jun.
  23. Cheng, Yin-Wong, 1993. "Exchange rate risk premiums," Journal of International Money and Finance, Elsevier, vol. 12(2), pages 182-194, April.
  24. Goldberg, Michael D & Frydman, Roman, 1996. "Imperfect Knowledge and Behaviour in the Foreign Exchange Market," Economic Journal, Royal Economic Society, vol. 106(437), pages 869-93, July.
  25. Jeffrey Frankel & Menzie Chinn, 1991. "Exchange Rate Expectations and the Risk Premium: Tests For a Cross- Section of 17 Currencies," NBER Working Papers 3806, National Bureau of Economic Research, Inc.
  26. Lothian, James R & Taylor, Mark P, 1996. "Real Exchange Rate Behavior: The Recent Float from the Perspective of the Past Two Centuries," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 488-509, June.
  27. Geert Bekaert & Robert J. Hodrick, 1991. "On Biases in the Measurement of Foreign Exchange Risk Premiums," NBER Working Papers 3861, National Bureau of Economic Research, Inc.
  28. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  29. Lars Peter Hansen & Robert J. Hodrick, 1983. "Risk Averse Speculation in the Forward Foreign Exchange Market: An Econometric Analysis of Linear Models," NBER Chapters, in: Exchange Rates and International Macroeconomics, pages 113-152 National Bureau of Economic Research, Inc.
  30. Mark, Nelson C, 1995. "Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability," American Economic Review, American Economic Association, vol. 85(1), pages 201-18, March.
  31. Engel, Charles M., 1984. "Testing for the absence of expected real profits from forward market speculation," Journal of International Economics, Elsevier, vol. 17(3-4), pages 299-308, November.
  32. Cavaglia, Stefano M F G & Verschoor, Willem F C & Wolff, Christian C P, 1994. "On the Biasedness of Forward Foreign Exchange Rates: Irrationality or Risk Premia?," The Journal of Business, University of Chicago Press, vol. 67(3), pages 321-43, July.
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