Solution to the Siegel paradox

The Siegel Paradox in international finance arises because the equilibrium conditions in foreign exchange markets violate Jensen's Inequality. This paper shows that in the original risk-neutral framework (Siegel, 1972), or more accurately a rational representative-agent setting, the paradox does not exist because the conditional probability distribution of the expected spot rate follows a degenerate distribution. When this overlooked condition is incorporated, Jensen's Inequality holds with equality and the paradox vanishes. However, the paradox may still exist when rational agents are heterogeneous and form expectations independently and differently. The result of this paper has implications for both theoretical and empirical studies in international finance.