The Uncovered Interest Parity Puzzle and Other Anomalies
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.
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