Working Paper: CEPR ID: DP6122
Authors: Philippe Bacchetta; Eric van Wincoop
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 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.
Keywords: excess return; incomplete information; predictability
JEL Codes: E4; F3; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| random walk expectations (C69) | forward premium puzzle explained (F31) |
| frequency of portfolio adjustments (G11) | depreciation of high interest rate currencies (F31) |
| infrequent portfolio adjustments (G11) | appreciation of high interest rate currencies (F31) |
| interest differentials (E43) | exchange rate predictability (F31) |
| frequency of portfolio adjustments (G11) | exchange rate changes (F31) |