Random Walk Expectations and the Forward Discount Puzzle

16 Pages Posted: 3 Jul 2007 Last revised: 1 Aug 2022

See all articles by Philippe Bacchetta

Philippe Bacchetta

University of Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Eric van Wincoop

University of Virginia - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: June 2007

Abstract

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.

Suggested Citation

Bacchetta, Philippe and van Wincoop, Eric, Random Walk Expectations and the Forward Discount Puzzle (June 2007). NBER Working Paper No. w13205, Available at SSRN: https://ssrn.com/abstract=997561

Philippe Bacchetta

University of Lausanne ( email )

Faculty of Business and Economics
Internef 523
1015 Lausanne
Switzerland

HOME PAGE: http://www.hec.unil.ch/pbacchetta/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
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CH-1211 Geneva 4
Switzerland

Eric Van Wincoop (Contact Author)

University of Virginia - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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United States

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