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 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.
|Date of creation:||Jun 2007|
|Date of revision:|
|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.|
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"Incomplete information processing: a solution to the forward discount puzzle,"
Working Paper Series
2006-35, Federal Reserve Bank of San Francisco.
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