Deviations from Rational Expectations and the Uncovered Interest Rate Parity Puzzle

This paper documents a novel result regarding the uncovered interest rate parity (UIP) puzzle: investing in high interest rate currencies does not yield positive excess returns during recessions. That is, the UIP holds in bad times. This new finding is a challenge to existing rational expectations models that address the UIP puzzle. A model featuring investors whose interest rate expectations are distorted by extrapolation bias and time-varying stickiness is able to quantitatively account for this evidence when calibrated to available survey data. The model also generates predictions for bond return predictability, the profitability of time-series momentum in the foreign exchange and fixed income markets, and foreign exchange predictability during the post-2007 period, which are borne out in the data