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Solution to the Siegel Paradox

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  • Kam Chu

Abstract

The Siegel Paradox in international finance arises because the equilibrium conditions in foreign exchange markets violate Jensen's Inequality. This paper shows that in the original risk-neutral framework (Siegel, 1972), or more accurately a rational representative-agent setting, the paradox does not exist because the conditional probability distribution of the expected spot rate follows a degenerate distribution. When this overlooked condition is incorporated, Jensen's Inequality holds with equality and the paradox vanishes. However, the paradox may still exist when rational agents are heterogeneous and form expectations independently and differently. The result of this paper has implications for both theoretical and empirical studies in international finance. Copyright Springer Science + Business Media, Inc. 2005

Suggested Citation

  • Kam Chu, 2005. "Solution to the Siegel Paradox," Open Economies Review, Springer, vol. 16(4), pages 399-405, October.
    • Handle: RePEc:kap:openec:v:16:y:2005:i:4:p:399-405
    DOI: 10.1007/s11079-005-4742-4
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    1. Carmen Gloria Silva, 2010. "Forward premium puzzle and term structure of interest rates: the case of New Zealand," Working Papers Central Bank of Chile 570, Central Bank of Chile.
    2. Marielle de Jong, 2011. "An adequate measure for exchange rate returns," Journal of Asset Management, Palgrave Macmillan, vol. 12(2), pages 85-93, June.

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