The role of endogenous uncertainty in foreign exchange markets

This study examines what role the concept of endogenous uncertainty can have in explaining two phenomena of international financial markets. Both the forward discount bias and the home bias puzzles are unexplained by models assuming economic agents have full knowledge of the structure of the economy. These two puzzles are explained by constructing overlapping generations models of Rational Belief Equilibria in a non-stationary environment where agents do not know the true probability distribution underlying asset price movements. The agents' beliefs are rational in the sense that their predictions of long term averages of economic variables match historical data. The equilibria of the models are solved numerically using the nonlinear equation solver TENSOLVE, which is well-suited to models containing multiple financial assets. The results confirm the underlying hypothesis that propagation of the beliefs of economic agents can play an important role in understanding international financial markets.