TY  - JOUR
AU  - Bacchetta,Philippe
AU  - Wincoop,Eric van
TI  - Random Walk Expectations and the Forward Discount Puzzle
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 13205
PY  - 2007
Y2  - June 2007
UR  - http://www.nber.org/papers/w13205
L1  - http://www.nber.org/papers/w13205.pdf
N1  - Author contact info:
Philippe Bacchetta
Faculty of Business and Economics
University of Lausanne
Extranef
CH-1015 Lausanne
Switzerland
E-Mail: philippe.bacchetta@unil.ch

Eric van Wincoop
Department of Economics
University of Virginia
P.O. Box 400182
Charlottesville, VA  22904-4182
Tel: 434/924-3997
Fax: 434/982-2904
E-Mail: vanwincoop@virginia.edu
AB  - 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.
ER  -