Explaining exchange rate anomalies in a model with Taylor-rule fundamentals and consistent expectations

Kevin Lansing and Jun Ma

Journal of International Money and Finance, 2017, vol. 70, issue C, 62-87

Abstract: We introduce boundedly-rational expectations into a standard asset-pricing model of the exchange rate, where cross-country interest rate differentials are governed by Taylor-type rules. Agents augment a lagged-information random walk forecast with a term that captures news about Taylor-rule fundamentals. The coefficient on fundamental news is pinned down using the moments of observable data such that the resulting forecast errors are close to white noise. The model generates volatility and persistence that is remarkably similar to that observed in monthly exchange rate data for Canada, Japan, and the U.K. Regressions performed on model-generated data can deliver the well-documented forward premium anomaly.

Keywords: Exchange rates; Uncovered interest rate parity; Forward premium anomaly; Random-walk expectations; Excess volatility (search for similar items in EconPapers)
JEL-codes: D83 D84 E44 F31 G17 (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (9)

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Related works:
Working Paper: Explaining Exchange Rate Anomalies in a Model with Taylor-Rule Fundamentals and Consistent Expectations (2014)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:70:y:2017:i:c:p:62-87

DOI: 10.1016/j.jimonfin.2016.08.004

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