Model Uncertainty and Foreign Exchange Predictability: A Robust Explanation of the Forward Premium Puzzle

I show that concerns for robustness against model uncertainty generate predictable, time-varying violations of uncovered interest parity in a multi-country endowment economy where representative agents average over competing sub-models of growth processes to determine interest rates. I test the theory using consumption and foreign exchange data for several countries, and find that the model's measure of expected currency returns generally explains and predicts actual foreign exchange returns relative to the U.S. Dollar better than the time series of currency forward premiums or interest rate differences.