DP6122 Random Walk Expectations and the Forward Discount Puzzle

Author(s): Philippe Bacchetta , Eric van Wincoop

Publication Date: February 2007

Keyword(s): excess return , incomplete information , predictability

JEL(s): E4 , F3 , G1

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6122.asp.asp

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.