Rational Inattention: A Solution to the Forward Discount Puzzle

Philippe Bacchetta and Eric van Wincoop

FAME Research Paper Series from International Center for Financial Asset Management and Engineering

Abstract: The uncovered interest rate parity equation is the cornerstone of most models in international macro. However, this equation does not hold empirically since the forward discount, or interest rate differential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle is one of the most extensively researched areas in international finance. It implies that excess returns on foreign currency investments are predictable. In this paper we propose a new explanation for this puzzle based on rational inattention. We develop a model where investors face a cost of collecting and processing information. Investors with low information processing costs trade actively, while other investors are inattentive and trade infrequently. We calibrate the model to the data and show that (i) inattention can account for most of the observed predictability of excess returns in the foreign exchange market, (ii) the benefit from frequent trading is relatively small so that few investors choose to be attentive, (iii) average expectational errors about future exchange rates are predictable in a way consistent with survey data for market participants, and (iv) the model can account for the puzzle of delayed overshooting of the exchange rate in response to interest rate shocks.

Keywords: forward discount puzzle; excess return predictability; rational (search for similar items in EconPapers)
JEL-codes: E44 F31 F37 G1 (search for similar items in EconPapers)
Date: 2005-09
New Economics Papers: this item is included in nep-fin, nep-ifn and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (32)

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Related works:
Working Paper: Rational Inattention: A Solution to the Forward Discount Puzzle (2005)
Working Paper: Rational Inattention: A Solution to the Forward Discount Puzzle (2005)
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