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American Economic Review: Vol. 100 No. 3 (June 2010)

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Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle

Article Citation

Bacchetta, Philippe, and Eric van Wincoop. 2010. "Infrequent Portfolio Decisions: A Solution to the Forward Discount Puzzle." American Economic Review, 100(3): 870-904.

DOI: 10.1257/aer.100.3.870

Abstract

A major puzzle in international finance is that high interest rate currencies tend to appreciate (forward discount puzzle). Motivated by the fact that only a small fraction of foreign currency holdings is actively managed, we calibrate a two-country model in which agents make infrequent portfolio decisions. We show that the model can account for the forward discount puzzle. It can also account for several related empirical phenomena, including that of "delayed overshooting." We also show that making infrequent portfolio decisions is optimal as the welfare gain from active currency management is smaller than the corresponding fees. (JEL F31, G11, G15)

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Authors

Bacchetta, Philippe (U Lausanne and Swiss Finance Institute)
van Wincoop, Eric (U VA)

JEL Classifications

F31: Foreign Exchange
G11: Portfolio Choice; Investment Decisions
G15: International Financial Markets


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