Random Walk Expectations and the Forward Discount Puzzle

Philippe Bacchetta and Eric van Wincoop

Cahiers de Recherches Economiques du Département d'économie from Université de Lausanne, Faculté des HEC, Département d’économie

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 premium 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.

Keywords: excess returns; incomplete information; predictability (search for similar items in EconPapers)
JEL-codes: E4 F3 G1 (search for similar items in EconPapers)
Pages: 13 pages + fig.
Date: 2007-01
New Economics Papers: this item is included in nep-cba, nep-fmk, nep-ifn, nep-mac and nep-mon
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Citations: View citations in EconPapers (24)

Published in American Economic Review, Papers and Proceedings, 97, May 2007, pp. 346-350

Downloads: (external link)
http://www.hec.unil.ch/deep/textes/07.01.pdf (application/pdf)

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)
Working Paper: Random Walk Expectations and the Forward Discount Puzzle (2007)
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Persistent link: https://EconPapers.repec.org/RePEc:lau:crdeep:07.01

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