Rational Inattention: A Solution to the Forward Discount Puzzle

40 Pages Posted: 22 Nov 2005 Last revised: 8 Dec 2005

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: September 2005

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 is one of the most extensively researched areas in international finance. It implies that excess returns on foreign currency investments are predictable. In this paper we propose a new explanation for this puzzle based on rational inattention. We develop a model where investors face a cost of collecting and processing information. Investors with low information processing costs trade actively, while other investors are inattentive and trade infrequently. We calibrate the model to the data and show that (i) inattention can account for most of the observed predictability of excess returns in the foreign exchange market, (ii) the benefit from frequent trading is relatively small so that few investors choose to be attentive, (iii) average expectational errors about future exchange rates are predictable in a way consistent with survey data for market participants, and (iv) the model can account for the puzzle of delayed overshooting of the exchange rate in response to interest rate shocks.

Suggested Citation

Bacchetta, Philippe and van Wincoop, Eric, Rational Inattention: A Solution to the Forward Discount Puzzle (September 2005). NBER Working Paper No. w11633, Available at SSRN: https://ssrn.com/abstract=812007

Philippe Bacchetta (Contact Author)

University of Lausanne ( email )

Faculty of Business and Economics
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1015 Lausanne
Switzerland

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

Centre for Economic Policy Research (CEPR)

London
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Swiss Finance Institute

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Eric Van Wincoop

University of Virginia - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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