Working Paper: CEPR ID: DP5261
Authors: Philippe Bacchetta; Eric van Wincoop
Abstract: The uncovered interest rate parity equation is the cornerstone of most models in international macro. However, this equation does not hold empirically since the forward discount, or interest rate differential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle is one of the most extensively researched areas in international finance. It implies that excess returns on foreign currency investments are predictable. In this paper we propose a new explanation for this puzzle based on rational inattention. We develop a model where investors face a cost of collecting and processing information. Investors with low information processing costs trade actively, while other investors are inattentive and trade infrequently. We calibrate the model to the data and show that (i) inattention can account for most of the observed predictability of excess returns in the foreign exchange market, (ii) the benefit from frequent trading is relatively small so that few investors choose to be attentive, (iii) average expectational errors about future exchange rates are predictable in a way consistent with survey data for market participants, and (iv) the model can account for the puzzle of delayed overshooting of the exchange rate in response to interest rate shocks.
Keywords: Excess Return; Predictability; Forward Discount Puzzle; Rational Inattention
JEL Codes: E44; F31; F37; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| rational inattention (D80) | forward discount puzzle (C69) |
| inattention (D91) | predictable expectational errors (D84) |
| predictable expectational errors (D84) | forward premium (G13) |
| inattention (D91) | delayed responses to market changes (L16) |
| inattention (D91) | low R-squared in excess return regressions (C29) |
| inattention (D91) | delayed overshooting of exchange rate (F31) |
| interest rate shocks (E43) | delayed response of exchange rates (F31) |
| forward discount (G13) | excess returns (D46) |