Rethinking Deviations From Uncovered Interest Parity: the Role of Covariance Risk and Noise

Nelson Chung Mark · Yangru Wu

171 citations0/0 files storedThe Economic Journal

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Financial Markets and Investment Strategies Monetary Policy and Economic Impact Global Financial Crisis and Policies

Abstract

We examine the ability of the standard intertemporal asset pricing model and a model of noise trading to explain why the forward foreign exchange premium predicts the future currency depreciation with the ‘wrong’ sign. We find that the intertemporal asset pricing model is unable to predict risk premia with the correct sign to be consistent with the data. The noise‐trader model, while highly stylised, receives fragmentary support from empirical research on survey expectations.

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1985Does the Stock Market Overreact?1990Noise Trader Risk in Financial Markets 1984Forward and spot exchange rates 1990Implications of Security Market Data for Models of Dynamic Economies 1995Exchange rates and fundamentals: Evidence on long-horizon predictability 1990Anomalies: Foreign Exchange 1996Real Exchange Rate Behavior: The Recent Float from the Perspective of the Past Two Centuries 2002The Message in Daily Exchange Rates

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2011Investor Overconfidence and the Forward Premium Puzzle 2000Cointegration and forward and spot exchange rate regressions 2010Speculative capital and currency carry trades 2008Can perpetual learning explain the forward-premium puzzle?2011Carry trades, momentum trading and the forward premium anomaly 2013A sentiment-based explanation of the forward premium puzzle

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