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Ambiguity Aversion: Implications For The Uncovered Interest Rate Parity Puzzle

  • COSMIN ILUT

    (NORTHWESTERN UNIVERSITY)

positive domestic interest rate differential predicts that the domestic currency will appreciate in the future. The reason capital inflows into high-interest-rate currencies are limited in the model is that agents tend to overstate the probability of a future depreciation. I show that my result cannot be duplicated in a simple model with risk aversion. In addition to providing a resolution to the UIP puzzle, the model predicts, consistent with the data, negative skewness and excess kurtosis for carry trade payoffs and positive average payoffs even for hedged positions.

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Paper provided by Society for Economic Dynamics in its series 2009 Meeting Papers with number 328.

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Date of creation: 2009
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Handle: RePEc:red:sed009:328
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  1. Isaac Kleshchelski & Nicolas Vincent, 2007. "Robust Equilibrium Yield Curves," Cahiers de recherche 08-02, HEC Montréal, Institut d'économie appliquée.
  2. Xavier Gabaix, 2012. "Variable Rare Disasters: An Exactly Solved Framework for Ten Puzzles in Macro-Finance," The Quarterly Journal of Economics, Oxford University Press, vol. 127(2), pages 645-700.
  3. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Boston University - Department of Economics - Working Papers Series WP2006-047, Boston University - Department of Economics.
  4. Farhi, Emmanuel & Gabaix, Xavier, 2015. "Rare Disasters and Exchange Rates," CEPR Discussion Papers 10334, C.E.P.R. Discussion Papers.
  5. John C. Williams & Andrew T. Levin, 2003. "Robust Monetary Policy with Competing Reference Models," Computing in Economics and Finance 2003 291, Society for Computational Economics.
  6. Almuth Scholl & Harald Uhlig, 2006. "New Evidence on the Puzzles: Monetary Policy and Exchange Rates," Computing in Economics and Finance 2006 5, Society for Computational Economics.
  7. Philippe Bacchetta & Elmar Mertens & Eric van Wincoop, 2006. "Predictability in Financial Markets: What Do Survey Expectations Tell Us?," Working Papers 06.04, Swiss National Bank, Study Center Gerzensee.
  8. Tomasz Strzalecki, 2011. "Axiomatic Foundations of Multiplier Preferences," Levine's Working Paper Archive 786969000000000126, David K. Levine.
  9. Hanno Lustig & Adrien Verdelhan, 2004. "The Cross-Section of Foreign Currency Risk Premia and US Consumption Growth Risk," 2004 Meeting Papers 136c, Society for Economic Dynamics.
  10. Larry Epstein & Martin Schneider, 2006. "Learning Under Ambiguity," RCER Working Papers 527, University of Rochester - Center for Economic Research (RCER).
  11. Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
  12. Lucio Sarno, 2005. "Towards a Solution to the Puzzles in Exchange Rate Economics: Where Do We Stand?," Working Papers wp05-11, Warwick Business School, Finance Group.
  13. Emmanuel Farhi, 2008. "Rare Disasters and Exchange Rates," 2008 Meeting Papers 47, Society for Economic Dynamics.
  14. George W. Evans & Avik Chakraborty, 2006. "Can Perpetual Learning Explain the Forward Premium Puzzle?," University of Oregon Economics Department Working Papers 2006-8, University of Oregon Economics Department, revised 20 Aug 2006.
  15. Francois Gourio, 2008. "Disasters and Recoveries," American Economic Review, American Economic Association, vol. 98(2), pages 68-73, May.
  16. Kaminsky, Graciela, 1993. "Is There a Peso Problem? Evidence from the Dollar/Pound Exchange Rate, 1976-1987," American Economic Review, American Economic Association, vol. 83(3), pages 450-72, June.
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