Uncovered interest parity — why does it fail?

Brad DeLong asks:

This is one of the most puzzling puzzles in macroeconomics: that foreign-exchange speculators are not very good at linking domestic money and bond markets to the foreign exchange market. Not enough money seems to be engaged in betting that a currency with a high nominal interest rates will not decline in value fast enough to make investing in its securities unprofitable. Why not? It’s an easy thing to do.

James Hamilton [correction: *Menzie Chinn*] adds more.  What are the main hypotheses for why high nominal interest rate currencies appear to outperform the market?

1. The so-called "peso problem."  Someday the roof will cave in on these currencies.  The Asian financial crisis was only a small disruption compared to what will happen someday.  Our current data set is incomplete and does not represent the real population.

2. Holding crummy currencies is riskier than CAPM and variants indicate.  Most likely, the relevant investors are not and cannot be well-diversified.  So their high pecuniary returns are offset by the risk they bear.  If thirty percent of your wealth is in the South African Rand, the relevant measure of your risk may be the variance of that currency, not the covariance of that currency with some broader international market portfolio.  Economic theory usually measures risk by looking at the latter.

3. Many investors stay away from crummy, high nominal interest rate currencies for fear of what their wives (or bosses, consider an agency problem at a financial firm) would say, should they lose money.  The relevant markets are segmented.  This is linked to #2.

4. This used to be a puzzle, but now the profit opportunity has been identified.  The supposed additional risk of the high nominal interest rate currency is phantom.  People now jump into high nominal interest rate currencies, at least when such investments are appropriate to restore an equilibrium of risks and returns.  We should expect the paradox to disappear in future data sets.

Observation: Do not ever write or say "CAPM model."  Do not ever write or say "ATM machine."


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