RDP 9307: Explaining Forward Discount Bias: Is it Anchoring? Appendix C: Asset Supplies not Equal to the Traders' Minimum-Variance Portfolio

In this case, the international arbitrage condition, equation (10), becomes

In the absence of domestic money shocks, the definitions of and imply p_t = and s_t = . Then, with anchored traders' expectations again given by equation (8), while . To satisfy (C1) requires

where x = κγ/(1 – α). The excess return on the foreign asset, x, is a risk premium required in the aggregate by the traders to increase their holdings of the foreign asset from g to g + κ. Reintroducing domestic money shocks implies time-evolutions for the interest differential and domestic prices which satisfy (C3) and (C4):

Equations (C3) and (C4) replace (5) and (6) in the text. It is now straightforward, if tedious, to solve the model and derive equations (13) and (14).