Chapter 6: Synthesis Model II
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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