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Random Walk Expectations and the Forward Discount Puzzle

  • Eric van Wincoop
  • Philippe Bacchetta

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.

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 97 (2007)
Issue (Month): 2 (May)
Pages: 346-350

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Handle: RePEc:aea:aecrev:v:97:y:2007:i:2:p:346-350
Note: DOI: 10.1257/aer.97.2.346
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  1. Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2006. "The Returns to Currency Speculation," 2006 Meeting Papers 864, Society for Economic Dynamics.
  2. Philippe Bacchetta & Eric van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Working Paper Series 2006-35, Federal Reserve Bank of San Francisco.
  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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