Working Paper: NBER ID: w3319
Authors: Richard E. Baldwin
Abstract: Small transaction costs and uncertainty imply that optimal cross-currency interest rate speculation is marked by a first-order hysteresis band. Consequently uncovered interest parity does not hold and market efficiency tests based on it are misspecified. Indeed measured prediction errors are a combination of true prediction errors and a wedge that consists of the "option value" of being in foreign currency and either plus or minus the transaction cost. Due to the nature of this wedge, we should expect measured prediction errors to be serially correlated, correlated with the current forward rate and perhaps have a non-zero mean, if the interest differential itself is serially correlated. The existence of the wedge helps account both for the failure of market efficiency tests and the difficulties in finding an empirically successful model of the risk premium.
Keywords: No keywords provided
JEL Codes: No JEL codes provided
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| small transaction costs (D23) | first-order hysteresis band (C69) |
| first-order hysteresis band (C69) | failure of uncovered interest parity (F31) |
| small transaction costs (D23) | prediction errors (C52) |
| first-order hysteresis band (C69) | behavior of prediction errors (C52) |
| option value of holding foreign currencies + transaction costs (F31) | prediction errors (C52) |
| interest differential is serially correlated (C22) | measured prediction errors exhibit serial correlation (C22) |