Chapter 5: Synthesis Model I
Synthesis Model I, in this chapter, and Synthesis Model II in Chapter 6 differ according to whether: (a) carry-trade occurs until investors believe that ex ante UIP holds at the end of each period; or (b) ex ante UIP does not hold. Synthesis Model II is more general because it reduces to Synthesis Model I as the fx market approaches perfect efficiency. However, Synthesis Model I is useful because the fx market might very well be highly efficient at times, and because it provides insights into the workings of the fx market that are relevant in Synthesis Model II. This chapter uses much of the material from Chapter 4 to develop Synthesis Model I, which represents an intertemporal UIP framework wherein investors believe that ex ante UIP holds at the end of each time period. It allows for the possibility that expectations about future interest rates are, at times, incorrect. It is shown that this does not necessarily imply that investors violate Muth Rationality in the long run. The main thrust of research on the UIP puzzle deals with: (a) a variable “risk premium” that is appropriately correlated with the interest rate differential (ID); (b) exchange rate expectations errors that are appropriately correlated with ID; and/or (c) fx market inefficiency. This chapter formally includes (a) and a variant of (b). It investigates the conditions under which ex post UIP might be violated. Also, it shows that Synthesis Model I is consistent with eight of the ten puzzles given in Chapter 1.
You are not authenticated to view the full text of this chapter or article.
Elgaronline requires a subscription or purchase to access the full text of books or journals. Please login through your library system or with your personal username and password on the homepage.
Non-subscribers can freely search the site, view abstracts/ extracts and download selected front matter and introductory chapters for personal use.
Your library may not have purchased all subject areas. If you are authenticated and think you should have access to this title, please contact your librarian.