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Modeling the Term Structure of Exchange Rate Expectations

Author

Listed:
  • Christian Bauer

    (University of Trier)

  • Sebastian Horlemann

    (UniCredit Group/HVB, Munich)

Abstract

We develop a model of the term structure of exchange rate expectations by integrating interest parity into a microstructure model of foreign exchange and national bond markets. The spot rate's reaction to typical shocks is able to reproduce standard results (e.g. overshooting) without reference to other frictions like rigid prices. Both countries' yield curves influence the semi-elasticity of the spot exchange rate. Opposing exchange rate expectations for short and for long horizons reduce interest rate effects. Finally, we show that not all rational methods of expectation formation are mutually consistent and induce model ambiguity as a genuine source of the UIP puzzle.

Suggested Citation

  • Christian Bauer & Sebastian Horlemann, 2016. "Modeling the Term Structure of Exchange Rate Expectations," Annals of Economics and Finance, Society for AEF, vol. 17(2), pages 303-335, November.
    • Handle: RePEc:cuf:journl:y:2016:v:17:i:2:bauer
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    References listed on IDEAS

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    More about this item

    Keywords

    Exchange rates; Expectation; Term structure; Interest parity;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects

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