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Random Walk Expectations and the Forward Discount Puzzle

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  • Philippe Bacchetta
  • Eric van Wincoop

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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13205.

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Date of creation: Jun 2007
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Publication status: 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.
Handle: RePEc:nbr:nberwo:13205

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  1. Philippe Bacchetta & Eric van Wincoop, 2005. "Incomplete Information Processing: A Solution to the Forward Discount Puzzle," Working Papers 05.03, Swiss National Bank, Study Center Gerzensee.
  2. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2006. "The Returns to Currency Speculation," 2006 Meeting Papers 864, Society for Economic Dynamics.
  3. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  4. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
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Cited by:
  1. Loring, Grace & Lucey, Brian, 2013. "An analysis of forward exchange rate biasedness across developed and developing country currencies: Do observed patterns persist out of sample?," Emerging Markets Review, Elsevier, vol. 17(C), pages 14-28.
  2. Michael Jetter & Alex Nikolsko-Rzhevskyy, 2013. "Monetary Policy Shifts and the Forward Discount Puzzle," DOCUMENTOS DE TRABAJO CIEF 010729, UNIVERSIDAD EAFIT.
  3. Bernoth, Kerstin & de Vries, Casper G & von Hagen, Jürgen, 2010. "The Forward Premium Puzzle and Latent Factors Day by Day," CEPR Discussion Papers 7772, C.E.P.R. Discussion Papers.
  4. Nucera, Federico & Valente, Giorgio, 2013. "Carry trades and the performance of currency hedge funds," Journal of International Money and Finance, Elsevier, vol. 33(C), pages 407-425.
  5. Han, Bing & Hirshleifer, David & Wang, Tracy, 2005. "Investor Overconfidence and the Forward Discount Puzzle," MPRA Paper 6497, University Library of Munich, Germany, revised Dec 2007.
  6. Demosthenes N. Tambakis & Nikola Tarashev, 2012. "Systematic monetary policy and the forward premium puzzle," BIS Working Papers 396, Bank for International Settlements.
  7. Anella Munro, 2014. "Exchange rates, expected returns and risk," Reserve Bank of New Zealand Discussion Paper Series DP2014/01, Reserve Bank of New Zealand.
  8. Kerstin Bernoth & J�rgen von Hagen & Casper G. de Vries, 2007. "The Forward Premium Puzzle only emerges gradually," Tinbergen Institute Discussion Papers 07-033/2, Tinbergen Institute.

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