Random Walk Expectations and the Forward Discount Puzzle

Two well-known, but seemingly contradictory, features of exchange rates are thatthey are close to a random walk while at the same time exchange rate changesare predictable by interest rate differentials. In this paper we investigate whetherthese two features of the data may in fact be related. In particular, we ask whetherthe predictability of exchange rates by interest differentials naturally results whenparticipants in the FX market adopt random walk expectations. We find that random walk expectations can explain the forward premium puzzle, but only if FXportfolio 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.