Puzzling Exchange Rate Dynamics and Delayed Portfolio Adjustment
49 Pages Posted: 8 Jul 2019
Date Written: July 2, 2019
The objective of this paper is to show that the proposal by Froot and Thaler (1990) of delayed portfolio adjustment can account for a broad set of puzzles about the relationship between interest rates and exchange rates. The puzzles include:
i) the delayed overshooting puzzle;
ii) the forward discount puzzle (or Fama puzzle);
iii) the predictability reversal puzzle;
iv) the Engel puzzle (high interest rate currencies are stronger than implied by UIP);
v) the forward guidance exchange rate puzzle;
vi) the absence of a forward discount puzzle with long-term bonds.
These results are derived analytically in a simple two-country model with portfolio adjustment costs. Quantitatively, this approach can match all targeted moments related to these puzzles.
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