Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle

57 Pages Posted: 17 May 2010 Last revised: 19 May 2010

Date Written: March 1, 2010

Abstract

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.

Keywords: uncovered interest rate parity, carry trade, ambiguity aversion, robust filtering

JEL Classification: F31, G11, G14, D80

Suggested Citation

Ilut, Cosmin L., Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle (March 1, 2010). Economic Research Initiatives at Duke (ERID) Working Paper No. 33, Available at SSRN: https://ssrn.com/abstract=1609803

Cosmin L. Ilut (Contact Author)

Duke University ( email )

100 Fuqua Drive
Durham, NC 27708-0204
United States

HOME PAGE: http://econ.duke.edu/~cli2/index.html

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