Incomplete Information Processing: A Solution to the Forward Discount Puzzle

Federal Reserve Bank of San Francisco Working Paper No. 2006-35

53 Pages Posted: 6 Aug 2007

See all articles by Philippe Bacchetta

Philippe Bacchetta

University of Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Eric van Wincoop

University of Virginia - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: June 2006

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 implies that excess returns on foreign currency investments are predictable. In this paper we investigate to what extent incomplete information processing can explain this puzzle. We consider two types of incompleteness: infrequent and partial information processing. We calibrate a two-country general equilibrium model to the data and show that incomplete information processing can fully match the empirical evidence. It can also account for several related empirical phenomena, including that of "delayed overshooting." We show that incomplete information processing is consistent both with evidence that little capital is devoted to actively managing short-term currency positions and with a small welfare gain from active portfolio management. The gain is small because exchange rate changes are very hard to predict. The welfare gain is easily outweighed by a small cost of active portfolio management.

Suggested Citation

Bacchetta, Philippe and van Wincoop, Eric, Incomplete Information Processing: A Solution to the Forward Discount Puzzle (June 2006). Federal Reserve Bank of San Francisco Working Paper No. 2006-35, Available at SSRN: https://ssrn.com/abstract=1004808 or http://dx.doi.org/10.2139/ssrn.1004808

Philippe Bacchetta (Contact Author)

University of Lausanne ( email )

Faculty of Business and Economics
Internef 523
1015 Lausanne
Switzerland

HOME PAGE: http://www.hec.unil.ch/pbacchetta/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Eric Van Wincoop

University of Virginia - Department of Economics ( email )

Rouss Hall 114
P.O. Box 400182
Charlottesville, VA 22904-4182
United States
804-924-3997 (Phone)
804-982-2904 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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