NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Random Walk Expectations and the Forward Discount Puzzle

Philippe Bacchetta, Eric van Wincoop

NBER Working Paper No. 13205
Issued in June 2007
NBER Program(s):   IFM

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.

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Document Object Identifier (DOI): 10.3386/w13205

Published: 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. citation courtesy of

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