Chapter 4: Key features of the synthesis models
Chapters 5 and 6 construct UIP synthesis models that are consistent with almost all of the 10 puzzling facts given in Chapter 1. This chapter carefully examines the key elements in the synthesis models. These are: (a) an intertemporal UIP framework; (b) the existence of a threshold magnitude or “risk premium”; (c) a finite speculative time horizon for carry-trade; (d) an exchange rate multiplier; (e) the anticipated value for the spot rate in the near future; and (f) the possibility of an inefficient fx market. When transactions costs are zero and if investors are risk-neutral (as in Chapter 3), they attempt to predict future interest rate differentials over an infinitely long time horizon. It is explained below that the existence of risk-aversion means that their speculative time horizon becomes finite, denoted by “n”, and is very likely to be far from infinite. Consequently, they form expectations about interest rate differentials over only the next “n” periods. That is: (a) n(t) is the speculative time horizon in period t; (b) n(t+1) is the speculative time horizon in period t+1; and (c) n(t+k) is the horizon for any period t+k. Investors also formulate expectations about the value for the spot rate “n” periods into the future. In period t, this is denoted by s*(t). That is, s*(t) represents what investors believe (as of period t) will be the value for the spot rate “n(t)” periods later in period t+n(t).
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