Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle

Cosmin Ilut

No 10-53, Working Papers from Duke University, Department of Economics

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, ex-post profitability and negative skewness of currency speculation payoffs.

Keywords: uncovered interest rate parity; carry trade; ambiguity aversion; robust filtering (search for similar items in EconPapers)
JEL-codes: D80 F31 G11 G14 (search for similar items in EconPapers)
Pages: 57
Date: 2010
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Citations: View citations in EconPapers (20)

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Related works:
Journal Article: Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle (2012)
Working Paper: AMBIGUITY AVERSION: IMPLICATIONS FOR THE UNCOVERED INTEREST RATE PARITY PUZZLE (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:duk:dukeec:10-53

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