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Puey Ungphakorn
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Call for Papers: PIER Research Workshop 2025
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17 April 2018
20181523923200000
No. 084

Extrapolative Beliefs and Exchange Rate Markets

Abstract

Following Engel (2016) and Valchev (2015), this paper documents the relationship between interest rate differentials and differential returns on domestic and foreign bonds over time horizon using a broader data sample. I find that countries with higher contemporaneous interest rates earn excess positive bond returns initially in accordance with previous UIP literature. However, the sign of excess returns reverses in the medium run. Higher contemporaneous interest rates predict negative excess returns. Eventually, interest differentials have no excess return predictability. I argue that behavioral bubbles are natural and successful candidates in generating exchange rate dynamics observed in the data. In particular, I propose that investors rely not only on fundamentals (interest differentials) but also extrapolate past exchange rates when forming expectations. The proposed extrapolative model is consistent with both excess return patterns and survey evidence in the data.

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JEL: F31G15G41
Tags: uncovered interest rate parityexchange ratesexpectationsextrapolation
The views expressed in this workshop do not necessarily reflect the views of the Puey Ungphakorn Institute for Economic Research or the Bank of Thailand.
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Sarita Bunsupha
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