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American Economic Journal: Macroeconomics: Vol. 4 No. 3 (July 2012)

AEJ: Macro Volume. 4, Issue 3 | Previous ArticleNext Article

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Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle

Article 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.4.3.33

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)

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Authors

Ilut, Cosmin (Duke U)

JEL Classifications

D81: Criteria for Decision-Making under Risk and Uncertainty
F31: Foreign Exchange
G15: International Financial Markets

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