Random Walk Expectations and the Forward Discount Puzzle

Philippe Bacchetta and Eric van Wincoop

No 07.01, Working Papers from Swiss National Bank, Study Center Gerzensee

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 di erentials. 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 di erentials naturally results when participants in the FX market adopt random walk expectations. We nd 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 nd that high interest rate currencies depreciate much more than what UIP would predict.

Pages: 16 pages
Date: 2007-01
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
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Citations: View citations in EconPapers (24)

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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)
Working Paper: Random Walk Expectations and the Forward Discount Puzzle (2007)
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