Discussion paper

DP13839 Puzzling Exchange Rate Dynamics and Delayed Portfolio Adjustment

The objective of this paper is to show that the proposal by Froot and Thaler (1990)
of delayed portfolio adjustment can account for a broad set of puzzles about the
relationship between interest rates and exchange rates. The puzzles include: i) the
delayed overshooting puzzle; ii) the forward discount puzzle (or Fama puzzle); iii)
the predictability reversal puzzle; iv) the Engel puzzle (high interest rate currencies
are stronger than implied by UIP); v) the forward guidance exchange rate puzzle;
vi) the absence of a forward discount puzzle with long-term bonds. These results
are derived analytically in a simple two-country model with portfolio adjustment
costs. Quantitatively, this approach can match all targeted moments related to
these puzzles.


Bacchetta, P and E van Wincoop (2019), ‘DP13839 Puzzling Exchange Rate Dynamics and Delayed Portfolio Adjustment‘, CEPR Discussion Paper No. 13839. CEPR Press, Paris & London. https://cepr.org/publications/dp13839