Exchange Rates Under Robustness: The Forward Premium Puzzle and Momentum (November 2008), with Ming Li
- Abstract: We show that robustness against model misspecification can account for the forward premium puzzle through a combination of an exchange rate model and a robustness model under structured uncertainty. In equilibrium, optimizing agents, who hold no misperception about the model, distort their forecasts to attain robustness against potential misspecification. This forecast distortion generates a delayed overreaction of exchange rates to interest rate differential shocks that leads to a negative unconditional correlation between exchange rate changes and interest rate differentials, i.e., a negative Fama coefficient. Using change-of-measure techniques, we derive the familiar uncovered interest rate parity condition—under distorted expectations—and the Fama coefficient in closed-form. We calibrate our model with empirical estimates of key parameters and are able to generate a negative Fama coefficient under sufficient uncertainty-aversion. Extended Appendix to Exchange Rates Under Robustness: The Forward Premium Puzzle
Exchange Rate Puzzles and Distorted Beliefs (June 2003), with Pierre-Olivier Gourinchas
- Abstract: We propose a new explanation for the foreign exchange forward-premium and delayed-overshooting puzzles. We show that both puzzles arise from a systematic distortion in investor’s beliefs about the interest rate process. Accordingly, the forward premium is always a biased predictor of future depreciation; the bias can be so severe as to lead to negative coefficients in the ‘Fama’ regression. Delayed overshooting may or may not occur depending upon the persistence of interest rate innovations and the degree of misperception. We document empirically the extent of this distortion using survey data for G-7 countries against the U.S. and find that it is strong enough to account for these irregularities.
Exchange Rate Anomalies Under Model Misspecification: A Mixed Optimal/Robust Approach (January 2003)
- Abstract: Many asset pricing anomalies imply the existence of time-varying predictable excess returns, as well as short-run underreaction and long-run overreaction to news. The presence of short-sales constraints or of misperception has been often invoked to explain such patterns. In this paper I present a ‘mixed optimal/robust’ model with rational agents that hold no misperception and face no borrowing constraints. In equilibrium, agents do not borrow as much as they could, and filter news in ways that are consistent with the anomalies mentioned above. We use the model to rationalize the forward premium puzzle.
Robust-H_infinity Forecasting and Asset Pricing Anomalies (December 2001)
- Abstract: We present a Robust-H_infinity model that helps rationalize well known asset pricing anomalies, such as the predictability of excess returns, excess volatility, and the equity-premium puzzle. As with rational expectations (RE), agents’ forecasts are based on a rigorous optimization algorithm that does not presume misperceptions — it simply departs from some of the implicit assumptions that underlie RE. Agents fear the existence of misspecification and design strategies that will be robust against a very large class of misspecifications. The new element is that uncertainty cannot be modeled via probability distributions. We consider an asset pricing model where uncertainty is represented by unknown-but bounded disturbance sequences, as in the H_infinity -control literature. Agents must filter the ‘persistent’ component of a sequence of dividend observations in order to make consumption and portfolio decisions. We find that H_infinity forecasts are more sensitive to news than RE forecasts and equilibrium prices exhibit the anomalies previously mentioned.