Chapter 3: The intertemporal approach to UIP
This chapter carefully develops the intertemporal approach to uncovered interest parity, as first presented by Gourinchas and Tornell (2004). Traditional thinking about UIP is consistent with the assumption that investors engage in carry-trade for only one time period. On the other hand, the intertemporal approach formally allows for the time horizon associated with carry-trade to be greater than one period. Gourinchas and Tornell (G & T) show that their model is consistent with three of the puzzles in Chapter 1, namely: (a) the relatively high volatility of the exchange rate compared with interest rates and/or interest rate differentials; (b) the UIP puzzle; and (c) “delayed overshooting”. In addition, their model provides insights into (d) the fact that estimates of Fama’s _ coefficient are very unstable. Before explaining the difference between the traditional approach to UIP and the intertemporal approach, it is useful to review the difference between ex ante UIP versus ex post UIP. The former says that any anticipated profit from a gain in net interest via carry-trade (borrowing in a low interest rate, foreign, country and investing in a high interest rate country, the USA) over the next time period is expected to be eliminated via a depreciation of the currency in the high interest rate country. Ex post UIP refers to whether or not the currency of the high interest rate country actually depreciates in the next period by the amount that was anticipated. Ex ante UIP is an equilibrium condition, not a theory.
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