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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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13.3 Information Heterogeneity

The first deviation from the benchmark we consider is information heterogeneity as analyzed in Bacchetta and van Wincoop (2006). There is symmetric information dispersion in the sense that agents have private signals, but no agent has superior information. There are two types of information heterogeneity. First, agents have private information about the future level of the fundamental. Second, agents have private trading needs that are only known to themselves and are unrelated to expectations about the future fundamental. Examples of this are private liquidity needs, hedging needs, or private investment opportunities. This leads to a source of demand or supply of Foreign bonds that is unrelated to expected returns and is unobservable in the aggregate.

The main implication of having private information about future fundamentals is that the exchange rate becomes a source of information. Since the exchange rate reflects demand or supply from heterogeneous agents, it aggregates information about future fundamentals. However, the exchange rate is still a noisy signal, as in the noisy rational expectation literature, because of the unrelated private trading needs.

These two types of information heterogeneity lead to three changes to the model Eqs. (13.1)–(13.4). First, the UIP deviation ψt is equal to a risk premium. The “nonspeculative” liquidity or hedging needs are unrelated to expected returns and represent a separate source of risk. This risk premium ...

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