Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle

Cosmin Ilut

American Economic Journal: Macroeconomics, 2012, vol. 4, issue 3, 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)

JEL-codes: D81 F31 G15 (search for similar items in EconPapers)
Date: 2012
Note: DOI: 10.1257/mac.4.3.33
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Citations: View citations in EconPapers (68)

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Related works:
Working Paper: Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle (2010)
Working Paper: AMBIGUITY AVERSION: IMPLICATIONS FOR THE UNCOVERED INTEREST RATE PARITY PUZZLE (2009)
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