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Extrapolative Beliefs and Exchange Rate Markets

Sarita Bunsupha
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Sarita Bunsupha: Harvard University

PIER Discussion Papers from Puey Ungphakorn Institute for Economic Research

Abstract: Following Engel (2016) and Valchev (2015), this paper documents the relationship between interest rate differentials and differential returns on domestic and foreign bonds over time horizon using a broader data sample. I find that countries with higher contemporaneous interest rates earn excess positive bond returns initially in accordance with previous UIP literature. However, the sign of excess returns reverses in the medium run. Higher contemporaneous interest rates predict negative excess returns. Eventually, interest differentials have no excess return predictability. I argue that behavioral bubbles are natural and successful candidates in generating exchange rate dynamics observed in the data. In particular, I propose that investors rely not only on fundamentals (interest differentials) but also extrapolate past exchange rates when forming expectations. The proposed extrapolative model is consistent with both excess return patterns and survey evidence in the data.

Keywords: Uncovered Interest Rate Parity; Exchange Rates; Expectations; Extrapolation (search for similar items in EconPapers)
JEL-codes: F31 G15 G41 (search for similar items in EconPapers)
Pages: 70 pages
Date: 2018-04, Revised 2018-04
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Published in PIER Discussion Paper Series

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