Modeling the Term Structure of Exchange Rate Expectations

Christian Bauer and Sebastian Horlemann
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Sebastian Horlemann: UniCredit Group/HVB, Munich

Annals of Economics and Finance, 2016, vol. 17, issue 2, 303-335

Abstract: We develop a model of the term structure of exchange rate expectations by integrating interest parity into a microstructure model of foreign exchange and national bond markets. The spot rate's reaction to typical shocks is able to reproduce standard results (e.g. overshooting) without reference to other frictions like rigid prices. Both countries' yield curves influence the semi-elasticity of the spot exchange rate. Opposing exchange rate expectations for short and for long horizons reduce interest rate effects. Finally, we show that not all rational methods of expectation formation are mutually consistent and induce model ambiguity as a genuine source of the UIP puzzle.

Keywords: Exchange rates; Expectation; Term structure; Interest parity (search for similar items in EconPapers)
JEL-codes: D84 E43 F31 (search for similar items in EconPapers)
Date: 2016
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Persistent link: https://EconPapers.repec.org/RePEc:cuf:journl:y:2016:v:17:i:2:bauer

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