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: Suggested Citation
Do you have negative results from your research you’d like to share?
Recommended Papers
-
The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence
-
The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk
By Hanno N. Lustig and Adrien Verdelhan
-
The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk
By Hanno N. Lustig and Adrien Verdelhan
-
The Returns to Currency Speculation
By A. Craig Burnside, Martin Eichenbaum, ...
-
The Returns to Currency Speculation
By A. Craig Burnside, Martin Eichenbaum, ...
-
The Cross-Section of Currency Risk Premia and Us Consumption Growth Risk
By Hanno N. Lustig and Adrien Verdelhan
-
The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: A Reply
By Hanno N. Lustig and Adrien Verdelhan
-
The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: A Reply
By Hanno N. Lustig and Adrien Verdelhan
-
Carry Trades and Currency Crashes
By Markus K. Brunnermeier, Stefan Nagel, ...