Random Walk Expectations and the Forward Discount Puzzle

Philippe Bacchetta and Eric van Wincoop

No 13205, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Two well-known, but seemingly contradictory, features of exchange rates are that they are close to a random walk while at the same time exchange rate changes are predictable by interest rate differentials. In this paper we investigate whether these two features of the data may in fact be related. In particular, we ask whether the predictability of exchange rates by interest differentials naturally results when participants in the FX market adopt random walk expectations. We find that random walk expectations can explain the forward discount puzzle, but only if FX portfolio positions are revised infrequently. In contrast, with frequent portfolio adjustment and random walk expectations, we find that high interest rate currencies depreciate much more than what UIP would predict.

JEL-codes: F3 F31 F41 (search for similar items in EconPapers)
Date: 2007-06
New Economics Papers: this item is included in nep-cba, nep-for and nep-ifn
Note: IFM
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (24)

Published as Philippe Bacchetta & Eric van Wincoop, 2007. "Random Walk Expectations and the Forward Discount Puzzle," American Economic Review, American Economic Association, vol. 97(2), pages 346-350, May.

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Related works:
Journal Article: Random Walk Expectations and the Forward Discount Puzzle (2007)
Working Paper: Random Walk Expectations and the Forward Discount Puzzle (2007)
Working Paper: Random Walk Expectations and the Forward Discount Puzzle (2007)
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