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Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle
, 2009
"... Empirically, highinterestrate currencies tend to appreciate in the future relative to lowinterestrate currencies instead of depreciating as uncovered interest rate parity (UIP) states. The explanation for the UIP puzzle that I pursue in this paper is that the agents' beliefs are systemati ..."
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Cited by 25 (3 self)
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Empirically, highinterestrate currencies tend to appreciate in the future relative to lowinterestrate currencies instead of depreciating as uncovered interest rate parity (UIP) states. The explanation for the UIP puzzle that I pursue in this paper is that the agents' beliefs are systematically distorted. This perspective receives some support from an extended empirical literature using survey data. I construct a model of exchange rate determination in which ambiguityaverse agents need to solve a filtering problem to form forecasts but face signals about the timevarying hidden state that are of uncertain precision. In the presence of such uncertainty, ambiguityaverse agents take a worstcase evaluation of this precision and respond stronger to bad news than to good news about the payoffs of their investment strategies. Importantly, because of this endogenous systematic underestimation, agents in the next periods will perceive on average positive innovations about the payoffs which will make them reevaluate upwards the profitability of the strategy. As a result, the model's dynamics imply significant expost departures from UIP as equilibrium outcomes. In addition to providing a resolution to the UIP puzzle, the model predicts, consistent with the data, negative skewness and excess kurtosis for currency excess returns and positive average payoffs even for hedged positions.
Using Copulas to Construct Bivariate Foreign Exchange Distributions with an Application to the Sterling Exchange Rate
"... Abstract: We model the joint risk neutral distribution of the eurosterling and the dollarsterling exchange rates using optionimplied marginal distributions that are connected via a copula function that satisfies the triangular noarbitrage condition. We then derive a univariate distribution for ..."
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Cited by 19 (2 self)
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Abstract: We model the joint risk neutral distribution of the eurosterling and the dollarsterling exchange rates using optionimplied marginal distributions that are connected via a copula function that satisfies the triangular noarbitrage condition. We then derive a univariate distribution for a simplified sterling effective exchange rate index (ERI). Our results indicate that standard parametric copula functions, such as the commonly used Normal and Frank copulas, fail to capture the degree of asymmetry observed in the data. We overcome this problem by using a nonparametric dependence function in the form of a Bernstein copula which is shown to produce a very close fit. We further give an example of how our approach can be used to price currency index options accounting for strikedependent implied volatilities. We would like to thank Michael Bennett, Andrew Patton and Alessio Sancetta, participants at the CEF 2005 in Washington and the GFC 2005 in Dublin, as well as seminar participants at the Bank of England for useful comments and discussion. Any remaining mistakes are our own. This paper represents the views of the authors and should not be thought to represent those of the Bank of England and members of the Monetary Policy Committee. 2
Yield Curve Predictors of Foreign Exchange Returns ∗
, 2010
"... uncovered interest rate parity We thank Rudy LooKung for some research assistance work. We especially thank Bob Hodrick ..."
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Cited by 18 (0 self)
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uncovered interest rate parity We thank Rudy LooKung for some research assistance work. We especially thank Bob Hodrick
Estimation of a microfounded herding model of German survey expectations
, 2007
"... The paper considers the dynamic adjustments of an average opinion index that can be derived from a microfounded framework where the individual agents switch between two kinds of sentiment with certain transition probabilities. The index can thus represent a general business climate, i.e., expectatio ..."
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Cited by 14 (6 self)
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The paper considers the dynamic adjustments of an average opinion index that can be derived from a microfounded framework where the individual agents switch between two kinds of sentiment with certain transition probabilities. The index can thus represent a general business climate, i.e., expectations about the future course of the economy. This approach is empirically tested with the survey expectations published by the ZEW and ifo institute. The estimated coefficients make economic sense and are highly significant. In particular, besides effects from fundamental data like the output gap in the recent past, one can identify a strong herding mechanism within both panels, such that metaphorically speaking the agents do not just join the crowd but follow each single motion of it. In addition, the transition probabilities of the ZEW agents are found to be influenced by the ifo climate but not the other way round.
A Simple Asymmetric Herding Model to Distinguish Between Stock and Foreign Exchange Markets
"... Drawing on previous work of one of the authors, the paper takes an asymmetric variant of Kirman’s ant model and combines it with an elementary asset pricing mechanism. The closedform solution of the equilibrium probability distribution allows the specification of a tractable likelihood function for ..."
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Cited by 12 (3 self)
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Drawing on previous work of one of the authors, the paper takes an asymmetric variant of Kirman’s ant model and combines it with an elementary asset pricing mechanism. The closedform solution of the equilibrium probability distribution allows the specification of a tractable likelihood function for daily returns, which is then employed to estimate the model’s behavioural parameters for a large pool of Japanese stocks. By way of Monte Carlo simulations it is found that most of these markets belong to the same class, which is characterized by a dominance of the stylized noise traders. In contrast, the model assigns a number of major foreign exchange markets to a different class, where on average the majority of agents follows the fundamentalist trading rule. Implications for the tail index are also worked out.
What Does the Yield Curve Tell Us About Exchange Rate Predictability?
, 2009
"... This paper uses information contained in the crosscountry yield curves to test the assetpricing approach to exchange rate determination, which models the nominal exchange rate as the discounted present value of its expected future fundamentals. Since the term structure of interest rates embodies ..."
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Cited by 11 (0 self)
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This paper uses information contained in the crosscountry yield curves to test the assetpricing approach to exchange rate determination, which models the nominal exchange rate as the discounted present value of its expected future fundamentals. Since the term structure of interest rates embodies information about future economic activity such as GDP growth and inflation, we extract the NelsonSiegel (1987) factors of relative level, slope, and curvature from crosscountry yield differences to proxy expected movements in future exchange rate fundamentals. Using monthly
Modelling Ireland's exchange rates: from EMS to EMU, European Central Bank Working Papers, forthcoming
, 2007
"... This paper attempts to model the nominal and real exchange rate for Ireland, relative to Germany and the UK from 1975 to 2003. It offers an overview of the theory of purchasing power parity (Ppp), focusing particularly on likely sources of nonlinearity. Potential difficulties in placing the analysis ..."
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Cited by 9 (1 self)
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This paper attempts to model the nominal and real exchange rate for Ireland, relative to Germany and the UK from 1975 to 2003. It offers an overview of the theory of purchasing power parity (Ppp), focusing particularly on likely sources of nonlinearity. Potential difficulties in placing the analysis in the standard I(1)/I(0) framework are highlighted and comparisons with previous Irish studies are made. Tests for fractional integration and nonlinearity, including random field regressions, are discussed and applied. The results obtained highlight the likely inadequacies of the standard cointegration and Star approaches to modelling, and point instead to multiple structural changes models. Using this approach, both bilateral nominal exchange rates are effectively modelled, and in the case of Ireland and Germany, Ppp
Transaction Taxes, Traders’ Behavior and Exchange Rate Risks
"... Abstract: We propose a new model of chartistfundamentalistinteraction in which both groups of traders are allowed to select endogenously between different forecasting models and different investment horizons. Stochastic interest rates in both countries and different behavioral assumptions for tren ..."
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Cited by 9 (1 self)
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Abstract: We propose a new model of chartistfundamentalistinteraction in which both groups of traders are allowed to select endogenously between different forecasting models and different investment horizons. Stochastic interest rates in both countries and different behavioral assumptions for trendextrapolating and fundamental based forecasts determine the agents’ market orders which drive the exchange rate. A numerical analysis of the model shows that it is able to replicate stylized facts of observed financial return time series like excess kurtosis and volatility clustering. Within this framework we study the effects of transaction taxes on exchange rate volatility and traders ’ behavior measured by their population fractions. Simulations yield the result that on the macroscopic level these taxes reduce the variance of exchange rate returns, but also increase their kurtosis. Moreover, on the microscopic level the tax harms shortterm speculation in favor of longterm investment, while it also harms trading rules based on economic