IDEAS home Printed from https://ideas.repec.org/p/rba/rbardp/rdp9103.html

The Failure of Uncovered Interest Parity: Is it Near-rationality in the Foreign Exchange Market?

Author

Listed:
  • David W.R. Gruen

    (Reserve Bank of Australia)

  • Gordon D. Menzies

    (Reserve Bank of Australia)

Abstract

A risk-averse US investor adjusts the shares of a portfolio of short-term nominal domestic and foreign assets to maximize expected utility. The optimal strategy is to respond immediately to all new information which arrives weekly. We calculate the expected utility foregone when the investor abandons the optimal strategy and instead optimizes less frequently. We also consider the cases where the investor ignores the covariance between returns sourced in different countries, and where the investor makes unsystematic mistakes when forming expectations of exchange rate changes. We demonstrate that the expected utility cost of sub-optimal behaviour is generally very small. Thus, for example, if investors adjust portfolio shares every three months, they incur an average expected utility loss equivalent to about 0.16% p.a. It is therefore plausible that slight opportunity costs of frequent optimization may outweigh the benefits. This result may help explain the failure of uncovered interest parity.

Suggested Citation

  • David W.R. Gruen & Gordon D. Menzies, 1991. "The Failure of Uncovered Interest Parity: Is it Near-rationality in the Foreign Exchange Market?," RBA Research Discussion Papers rdp9103, Reserve Bank of Australia.
    • Handle: RePEc:rba:rbardp:rdp9103
    as

    Download full text from publisher

    File URL: https://www.rba.gov.au/publications/rdp/1991/pdf/rdp9103.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Cecchetti, Stephen G & Mark, Nelson C, 1990. "Evaluating Empirical Tests of Asset Pricing Models: Alternative Interpretations," American Economic Review, American Economic Association, vol. 80(2), pages 48-51, May.
    2. Frankel, Jeffrey A., 1988. "Recent estimates of time-variation in the conditional variance and in the exchange risk premium," Journal of International Money and Finance, Elsevier, vol. 7(1), pages 115-125, March.
    3. Frankel, Jeffrey A & Froot, Kenneth A, 1987. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," American Economic Review, American Economic Association, vol. 77(1), pages 133-153, March.
    4. Jeffrey A. Frankel & Richard Meese, 1987. "Are Exchange Rates Excessively Variable?," NBER Chapters, in: NBER Macroeconomics Annual 1987, Volume 2, pages 117-162, National Bureau of Economic Research, Inc.
    5. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    6. Frankel, Jeffrey & Engel, Charles M., 1984. "Do asset-demand functions optimize over the mean and variance of real returns? A six-currency test," Journal of International Economics, Elsevier, vol. 17(3-4), pages 309-323, November.
    7. Akerlof, George A & Yellen, Janet L, 1985. "Can Small Deviations from Rationality Make Significant Differences to Economic Equilibria?," American Economic Review, American Economic Association, vol. 75(4), pages 708-720, September.
    8. repec:bla:econom:v:55:y:1988:i:220:p:437-60 is not listed on IDEAS
    9. Baldwin, Richard, 1990. "Re-Interpreting the Failure of Foreign Exchange Market Efficiency Tests: Small Transaction Costs, Big Hysteresis Bands," CEPR Discussion Papers 407, C.E.P.R. Discussion Papers.
    10. Baillie, Richard T. & Bollerslev, Tim, 1990. "A multivariate generalized ARCH approach to modeling risk premia in forward foreign exchange rate markets," Journal of International Money and Finance, Elsevier, vol. 9(3), pages 309-324, September.
    11. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-192, Summer.
    12. Cumby, Robert E., 1988. "Is it risk? : Explaining deviations from uncovered interest parity," Journal of Monetary Economics, Elsevier, vol. 22(2), pages 279-299, September.
    13. Baillie, Richard T & Bollerslev, Tim, 2002. "The Message in Daily Exchange Rates: A Conditional-Variance Tale," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 60-68, January.
    14. Jeremy Smith & David W.R. Gruen, 1989. "A Random Walk Around the $A: Expectations, Risk, Interest Rates and Consequences for External Imbalance," RBA Research Discussion Papers rdp8906, Reserve Bank of Australia.
    15. Jeffrey A. Frankel & Kenneth A. Froot, 1985. "Using Survey Data to Test Some Standard Propositions Regarding Exchange Rate Expectations," NBER Working Papers 1672, National Bureau of Economic Research, Inc.
    16. Jeffrey A. Frankel, 1985. "The Dazzling Dollar," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 16(1), pages 199-217.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. K.F. Wallis, 1992. "On Macroeconomic Policy and Macroeconomic Modeling," Economics Discussion / Working Papers 92-04, The University of Western Australia, Department of Economics.
    2. Ross Guest & Ian McDonald, 1998. "The Socially Optimal Level of Saving in Australia, 1960‐61 to 1994‐95," Australian Economic Papers, Wiley Blackwell, vol. 37(3), pages 213-235, September.
    3. Alison Tarditi & Gordon Menzies, 1991. "Monthly Movements in the Australian Dollar and Real Short-term Interest Differentials: An Application of the Kalman Filter," RBA Research Discussion Papers rdp9111, Reserve Bank of Australia.
    4. Kenneth F. Wallis, 1993. "On Macroeconomic Policy and Macroeconometric Models," The Economic Record, The Economic Society of Australia, vol. 69(2), pages 113-130, June.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Gruen, D.W.R. & Gizycki, M.C., 1993. "Explaining Forward Discount Bias: Is It Anchoring?," Papers 164, Princeton, Woodrow Wilson School - Public and International Affairs.
    2. David W. R. Gruen & Gordon D. Menzies, 1995. "Forward Discount Bias: Is it Near‐Rationality in the Foreign Exchange Market?," The Economic Record, The Economic Society of Australia, vol. 71(2), pages 157-166, June.
    3. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
    4. Alison Tarditi & Gordon Menzies, 1991. "Monthly Movements in the Australian Dollar and Real Short-term Interest Differentials: An Application of the Kalman Filter," RBA Research Discussion Papers rdp9111, Reserve Bank of Australia.
    5. Tai, Chu-Sheng, 2003. "Can currency risk be a source of risk premium in explaining forward premium puzzle?: Evidence from Asia-Pacific forward exchange markets," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 13(4), pages 291-311, October.
    6. Baillie, Richard T. & Bollerslev, Tim, 2000. "The forward premium anomaly is not as bad as you think," Journal of International Money and Finance, Elsevier, vol. 19(4), pages 471-488, August.
    7. David W. R. Gruen & Jeremy Smith, 1994. "Excess Returns in a Small Open Economy," The Economic Record, The Economic Society of Australia, vol. 70(211), pages 381-396, December.
    8. Yushi Yoshida & Jan C. Rülke, 2009. "On-Going versus Completed Interventions and Yen/Dollar Expectations - Evidence from Disaggregated Survey Data," Discussion Papers 35, Kyushu Sangyo University, Faculty of Economics, revised Dec 2009.
    9. Tim Bollerslev & Ray Y. Chou & Narayanan Jayaraman & Kenneth F. Kroner - L, 1991. "es modéles ARCH en finance : un point sur la théorie et les résultats empiriques," Annals of Economics and Statistics, GENES, issue 24, pages 1-59.
    10. Baillie, Richard T. & Kilic, Rehim, 2006. "Do asymmetric and nonlinear adjustments explain the forward premium anomaly?," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 22-47, February.
    11. David W.R. Gruen, 1991. "The Effect of Steady Inflation on Interest Rates and the Real Exchange Rate in a World with Free Capital Flows," RBA Research Discussion Papers rdp9101, Reserve Bank of Australia.
    12. Owen F. Humpage & William P. Osterberg, 1992. "New results on the impact of central-bank intervention on deviations from uncovered interest parity," Working Papers (Old Series) 9207, Federal Reserve Bank of Cleveland.
    13. repec:adr:anecst:y:1991:i:24:p:01 is not listed on IDEAS
    14. Wagner, Christian, 2012. "Risk-premia, carry-trade dynamics, and economic value of currency speculation," Journal of International Money and Finance, Elsevier, vol. 31(5), pages 1195-1219.
    15. Tai, Chu-Sheng, 1999. "Time-varying risk premia in foreign exchange and equity markets: evidence from Asia-Pacific countries," Journal of Multinational Financial Management, Elsevier, vol. 9(3-4), pages 291-316, November.
    16. Zenón Jiménez-Ridruejo Ayuso & Mª Carmen Lorenzo Lago, 1996. "Análisis de variabilidad de la prima de riesgo," Estudios de Economia Aplicada, Estudios de Economia Aplicada, vol. 5, pages 33-57, Junio.
    17. Ross Levine, 1988. "The forward exchange rate bias: a new explanation," International Finance Discussion Papers 338, Board of Governors of the Federal Reserve System (U.S.).
    18. Elliott, Graham & Ito, Takatoshi, 1999. "Heterogeneous expectations and tests of efficiency in the yen/dollar forward exchange rate market," Journal of Monetary Economics, Elsevier, vol. 43(2), pages 435-456, April.
    19. Pasricha, Gurnain Kaur, 2006. "Survey of Literature on Covered and Uncovered Interest Parities," MPRA Paper 22737, University Library of Munich, Germany.
    20. Sonia Pangusión Espinosa., "undated". "Testing Uncovered Interest Rate Parity: The Spanish case," Studies on the Spanish Economy 128, FEDEA.
    21. Charles Engel & James D. Hamilton, 1989. "Long Swings in the Exchange Rate: Are they in the Data and Do Markets Know It?," NBER Working Papers 3165, National Bureau of Economic Research, Inc.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:rba:rbardp:rdp9103. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Paula Drew (email available below). General contact details of provider: https://edirc.repec.org/data/rbagvau.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.