Uncertainty aversion, carry trades and agent heterogeneity in the FX market

We examine the roles of heterogeneous agents in the foreign exchange (FX) market under the uncertainty framework. The empirical results show that uncertainty aversion is an important feature of heterogeneous agents’ behavior in the FX market, and inclusion of uncertainty-averse carry traders helps to improve the out-of-sample predictive performance. The carry traders’ activities are significantly affected by the interest rate differential and uncertainty aversion. They participated actively in the market before 2009 because of the large interest rate differential, and exited the market after the global financial crisis as the interest rate differential narrowed.