Modeling the Term Structure of Exchange Rate Expectations

Abstract

Recent approaches in international finance on exchange rates explicitly account for the maturity of interest rates. We integrate the interest parity idea into a modern microstructure model of foreign exchange and national bond markets and develop a model of the term structure of exchange rate expectations. The reaction function of the spot rate on changes of the basic economic variables such as the interest rate is generalized. This capital market model is able to reproduce standard results (e.g. overshooting) without reference to macroeconomic variables like rigid prices. In addition, the semi-elasticity of the spot exchange rate on interest rate changes depends on both the term structure of interest rates in both countries and determinants of the financial markets. The effects of interest rate changes on the spot exchange rate are diminished, if the exchange rate expectations for short and for long horizons have opposite signs. Finally, we show that there are several rational methods of building expectations which are not mutually consistent. This ambiguity of rational expectation building might contribute to explanations of the diversity of empirical results in the literature known as UIP puzzle.