The Failure of Uncovered Interest Parity: Is it Near-rationality in the Foreign Exchange Market?

David Gruen and Gordon Menzies

RBA Research Discussion Papers from Reserve Bank of Australia

Abstract: A risk-averse US investor adjusts the shares of a portfolio of short-term nominal domestic and foreign assets to maximize expected utility. The optimal strategy is to respond immediately to all new information which arrives weekly. We calculate the expected utility foregone when the investor abandons the optimal strategy and instead optimizes less frequently. We also consider the cases where the investor ignores the covariance between returns sourced in different countries, and where the investor makes unsystematic mistakes when forming expectations of exchange rate changes. We demonstrate that the expected utility cost of sub-optimal behaviour is generally very small. Thus, for example, if investors adjust portfolio shares every three months, they incur an average expected utility loss equivalent to about 0.16% p.a. It is therefore plausible that slight opportunity costs of frequent optimization may outweigh the benefits. This result may help explain the failure of uncovered interest parity.

Date: 1991-05
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