American Economic Journal:
Macroeconomics
ISSN 1945-7707 (Print) | ISSN 1945-7715 (Online)
Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle
American Economic Journal: Macroeconomics
vol. 4,
no. 3, July 2012
(pp. 33–65)
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, negative skewness, and time-series momentum for currency speculation payoffs. (JEL D81, F31, G15)Citation
Ilut, Cosmin. 2012. "Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle." American Economic Journal: Macroeconomics, 4 (3): 33–65. DOI: 10.1257/mac.4.3.33Additional Materials
JEL Classification
- D81 Criteria for Decision-Making under Risk and Uncertainty
- F31 Foreign Exchange
- G15 International Financial Markets
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