AMBIGUITY AVERSION: IMPLICATIONS FOR THE UNCOVERED INTEREST RATE PARITY PUZZLE

positive domestic interest rate differential predicts that the domestic currency will appreciate in the future. The reason capital inflows into high-interest-rate currencies are limited in the model is that agents tend to overstate the probability of a future depreciation. I show that my result cannot be duplicated in a simple model with risk aversion. In addition to providing a resolution to the UIP puzzle, the model predicts, consistent with the data, negative skewness and excess kurtosis for carry trade payoffs and positive average payoffs even for hedged positions.