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 dierentials. 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 dierentials 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.
Year of publication: |
2007-01
|
---|---|
Authors: | Bacchetta, Philippe ; Wincoop, Eric van |
Institutions: | Swiss National Bank, Study Center Gerzensee |
Saved in:
freely available
Saved in favorites
Similar items by person
-
Trade Flows, Prices, and The Exchange Rate Regime
Bacchetta, Philippe, (2000)
-
Can Parameter Instability Explain the Meese-Rogoff Puzzle?
Bacchetta, Philippe, (2009)
-
Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?
Bacchetta, Philippe, (2003)
- More ...