Ambiguity Aversion: Implications for the Uncovered Interest Rate Parity Puzzle

Empirically, high-interest-rate currencies tend to appreciate in the future relative to low-interest-rate currencies instead of depreciating as uncovered interest rate parity (UIP) states. The explanation for the UIP puzzle that I pursue in this paper is that the agents’ beliefs are systematically distorted. This perspective receives some support from an extended empirical literature using survey data. I construct a model of exchange rate determination in which ambiguity-averse agents need to solve a ltering,problem to form forecasts but face signals about the time-varying hidden state that are of uncertain precision. In the presence of such uncertainty, ambiguity- averse agents take a worst-case evaluation of this precision and respond stronger to bad news than to good news about the payos,of their investment strategies. Importantly, because of this endogenous systematic underestimation, agents in the next periods will perceive on average positive innovations about the payos,which will make them re-evaluate upwards the protability,of the strategy. As a result, the model’s dynamics imply signicant,ex-post departures from UIP as equilibrium outcomes. In addition to providing a resolution to the UIP puzzle, the model predicts, consistent with the data, negative skewness and excess kurtosis for currency excess returns and positive average payos,even for hedged positions. Key Words: uncovered interest rate parity, ambiguity aversion, robust ltering. JEL Classication : D8, E4, F3, G1. I am grateful to the members of my dissertation committee Lawrence Christiano, Martin Eichenbaum,