Random Walk Expectations and the Forward Discount Puzzle
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.
|Length:||13 pages + fig.|
|Date of creation:||Jan 2007|
|Publication status:||Published in American Economic Review, Papers and Proceedings, 97, May 2007, pp. 346-350|
|Contact details of provider:|| Postal: Université de Lausanne, Faculté des HEC, DEEP, Internef, CH-1015 Lausanne|
Phone: ++41 21 692.33.20
Web page: http://www.hec.unil.ch/deep/publications/cahiers/series
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- Philippe Bacchetta & Eric van Wincoop, 2005.
"Incomplete Information Processing: A Solution to the Forward Discount Puzzle,"
05.03, Swiss National Bank, Study Center Gerzensee.
- Philippe Bacchetta & Eric van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
- 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.
- Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
- Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2006.
"The Returns to Currency Speculation,"
NBER Working Papers
12489, National Bureau of Economic Research, Inc.
- Burnside, Craig & Eichenbaum, Martin & Kleshchelski, Isaac & Rebelo, Sérgio, 2006. "The Returns to Currency Speculation," CEPR Discussion Papers 5883, C.E.P.R. Discussion Papers.
- Craig Burnside & Martin Eichenbaum & Isaac Kleshchelski & Sergio Rebelo, 2006. "The Returns to Currency Speculation," 2006 Meeting Papers 864, Society for Economic Dynamics.
- 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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