Handbook of Exchange Rates

13.5 Infrequent Decision Making

As discussed in Section 13.2, in most applications, the UIP deviation in Equation (13.4) is a risk premium. Equating the expected excess return on Foreign bonds to a risk premium follows from any portfolio Euler equation that represents a trade-off between Home and Foreign bonds. It implicitly assumes that agents make new portfolio decisions each period on the basis of all available information. This assumption, although entirely standard in the literature, is nonetheless, a very strong and nonrealistic one. It implicitly assumes that all traders actively manage their FX exposure. Although there now exists an industry, developed in the late 1980s, that actively manages FX exposure (hedge funds, currency overlay managers, leveraged funds), it manages only a tiny fraction of cross-border financial holdings.¹⁰ Banks themselves actively manage FX positions mostly intraday. Mutual funds are not allowed by law to actively reallocate between Home and Foreign assets. A Europe fund is a Europe fund and cannot suddenly start investing in US bonds. Similarly, a global bond fund cannot suddenly start shorting one country's bonds when expected returns make this attractive. Moreover, Lyons (2001) reports that financial institutions rarely devote their own proprietary capital to currency strategies. Finally, individual investors are well known to make very infrequent portfolio decisions, especially regarding pension fund allocations.

In the models that we have ...