Puzzling Exchange Rate Dynamics and Delayed Portfolio Adjustment

49 Pages Posted: 8 Jul 2019

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)

Multiple version iconThere are 3 versions of this paper

Date Written: July 2, 2019

Abstract

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.

Suggested Citation

Bacchetta, Philippe and van Wincoop, Eric, Puzzling Exchange Rate Dynamics and Delayed Portfolio Adjustment (July 2, 2019). Swiss Finance Institute Research Paper No. 19-35, July 2019, Available at SSRN: https://ssrn.com/abstract=3414966 or http://dx.doi.org/10.2139/ssrn.3414966

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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