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|
|Date of revision:|
|Publication status:||Published in American Economic Review, Papers and Proceedings, 97, May 2007, pp. 346-350|
|Contact details of provider:|| Postal: |
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Web page: http://www.hec.unil.ch/deep/publications/cahiers/series
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"The Returns to Currency Speculation,"
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Working Paper Series
2006-35, Federal Reserve Bank of San Francisco.
- 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, 2005. "Incomplete Information Processing: A Solution to the Forward Discount Puzzle," Working Papers 05.03, Swiss National Bank, Study Center Gerzensee.
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