International macroe.. - Free

6.4. APPARENT VIOLATIONS OF RATIONALITY 1836.4 Apparent Violations of RationalityWe’ve seen that there are important dimensions of the data that the Lucasmodel with CRRA utility cannot explain. 8 What other approacheshave been taken to explain deviations from uncovered interest parity?This section covers the peso problem approach and the noise traderparadigm. Both approaches predict that market participants make systematicforecast errors. In the peso problem approach, agents have rationalexpectations but don’t know the true economic environment withcertainty. In the noise trading approach, some agents are irrational.Before tackling these issues, we want to have some evidence thatmarket participants actually do make systematic forecast errors. So weÞrst look at a line of research that studies the properties of exchangerate forecasts compiled by surveys of actual foreign exchange marketparticipants. The subjective expectations of market participants arekey to any theory in international Þnance. The rational expectationsassumption conveniently allows the economic analyst to model thesesubjective expectations without having to collect data on people’s expectationsper se. If the rational expectations assumption is wrong, itsviolation may be the reason that underlies asset-pricing anomalies suchas the deviation from uncovered interest parity.7 Backus, Gregory, and Telmer [4] investigate the lower volatility bound (6.28)implied by data on the U.S. dollar prices of the Canadian-dollar, the deutschemark,the French-franc, the pound, and the yen. They compute the bound for aninvestor who chases positive expected proÞts by deÞning forward exchange payoffson currency i as I it (F i,t − S i,t+1 )/S i,t where I it = 1 if E t (f i,t − s i,t+1 ) > 0andI it = 0 otherwise. The bound computed in the text does not make this adjustmentbecause it is not a prediction of the Lucas model where investors may be willingto take a position that earns expected negative proÞt ifitprovidesconsumptioninsurance. Using the indicator adjustment on returns lowers the volatility boundmaking it more difficult for the asset pricing model to match this quarterly dataset.8 The failure of the model to generate sufficiently variable risk premiums to explainthe data cannot be blamed on the CRRA utility function. Bekaert [9] obtainssimilar results with utility speciÞcations where consumption exhibits durability andwhen utility displays ‘habit persistence’.