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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 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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Paper provided by Swiss National Bank, Study Center Gerzensee in its series Working Papers with number 07.01.

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Length: 16 pages
Date of creation: Jan 2007
Date of revision:
Handle: RePEc:szg:worpap:0701
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  1. Burnside, Craig & Eichenbaum, Martin & Kleshchelski, Isaac & Rebelo, Sérgio, 2006. "The Returns to Currency Speculation," CEPR Discussion Papers 5883, C.E.P.R. Discussion Papers.
  2. 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.
  3. 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.
  4. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
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