Exchange Rate Economics

Exchange Rate Economics

The Uncovered Interest Parity Puzzle and Other Anomalies

Norman C. Miller

The Uncovered Interest Parity (UIP) puzzle has remained a moot point since it first circulated economic discourse in 1984 and, despite a number of attempts at a solution, the UIP puzzle and other anomalies in Exchange Rate Economics continue to perplex economic thought in international finance. This fundamental book fill gaps in scholarly literature by amalgamating key discourse to generate synthesis models which appear consistent with the UIP puzzle and related anomalies, uniquely bringing them together in one place. Through a comprehensive and current review of the literature, Norman C. Miller reveals new explanations for exchange rate anomalies and offers an alternative approach towards the UIP puzzle, stimulating and guiding future research.

Chapter 6: Synthesis Model II

Norman C. Miller

Subjects: economics and finance, financial economics and regulation, history of economic thought, international economics


Synthesis Model I assumes that investors engage in carry-trade until they believe that ex ante UIP exists at the end of each time period. It is consistent with the UIP puzzle for four reasons: (a) the “risk premium”, ρ, might be positively correlated with the interest rate differential (ID); (b) changes in what investors anticipate for the spot rate’s value at the end of their speculative time horizon, ds*, can be negatively correlated with ID; (c) the actual rate of decay in ID might be less than what investors anticipate over the relevant time interval; and (d) investors decrease their anticipated rate of decay in ID. A variable ρ has been prominent in the UIP puzzle literature. The ds* variable has not been recognized as a missing variable in a Fama regression. However, ds* is a prediction error if the speculative time horizon is one period, and if investors believe that “s” exhibits a random walk. Reason (d) is relatively new via the paper by Gourinchas and Tornell (2004). Finally, reason (c) is implicit in Gourinchas and Tornell, but they do not make it explicit. Reasons (c) and (d) have received no attention in the UIP literature. Synthesis Model I is consistent with eight of the ten puzzling facts about exchange rates given in Chapter 1. This chapter constructs Synthesis ModeI II, which adds another possible reason for the UIP puzzle, namely, the assumption that the exchange rate does not adjust enough in any one period to satisfy ex ante UIP.

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