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Investor Overconfidence and the Forward Premium Puzzle

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Author Info

  • Craig Burnside
  • Bing Han
  • David Hirshleifer
  • Tracy Yue Wang

Abstract

We offer an explanation for the forward premium puzzle in foreign exchange markets based upon investor overconfidence. In the model, overconfident individuals overreact to their information about future inflation, which causes greater overshooting in the forward rate than in the spot rate. Thus, when agents observe a signal of higher future inflation, the consequent rise in the forward premium predicts a subsequent downward correction of the spot rate. The model can explain the magnitude of the forward premium bias and several other stylized facts related to the joint behaviour of forward and spot exchange rates. Our approach is also consistent with the availability of profitable carry trade strategies. Copyright 2011, Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/restud/rdq013
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Bibliographic Info

Article provided by Oxford University Press in its journal The Review of Economic Studies.

Volume (Year): 78 (2011)
Issue (Month): 2 ()
Pages: 523-558

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Handle: RePEc:oup:restud:v:78:y:2011:i:2:p:523-558

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Cited by:
  1. Lukas Menkhoff & Lucio Sarno & Maik Schmeling & Andreas Schrimpf, 2012. "Currency Momentum Strategies," Working Paper Series 09_12, The Rimini Centre for Economic Analysis.
  2. Hanno Lustig & Adrien Verdelhan, 2008. "The Cross-Section of Foreign Currency Risk Premia and Consumption Growth Risk: A Reply," NBER Working Papers 13812, National Bureau of Economic Research, Inc.
  3. Snaith, Stuart & Coakley, Jerry & Kellard, Neil, 2013. "Does the forward premium puzzle disappear over the horizon?," Journal of Banking & Finance, Elsevier, vol. 37(9), pages 3681-3693.
  4. Loring, Grace & Lucey, Brian, 2013. "An analysis of forward exchange rate biasedness across developed and developing country currencies: Do observed patterns persist out of sample?," Emerging Markets Review, Elsevier, vol. 17(C), pages 14-28.
  5. Yu, Jianfeng, 2013. "A sentiment-based explanation of the forward premium puzzle," Journal of Monetary Economics, Elsevier, vol. 60(4), pages 474-491.
  6. Steinar Holden, 2012. "Implications of insights from behavioral economics for macroeconomic models," IMK Working Paper 99-2012, IMK at the Hans Boeckler Foundation, Macroeconomic Policy Institute.
  7. Bakshi, Gurdip & Panayotov, George, 2013. "Predictability of currency carry trades and asset pricing implications," Journal of Financial Economics, Elsevier, vol. 110(1), pages 139-163.
  8. Lee, Hsiu-Chuan & Chang, Shu-Lien, 2013. "Spillovers of currency carry trade returns, market risk sentiment, and U.S. market returns," The North American Journal of Economics and Finance, Elsevier, vol. 26(C), pages 197-216.

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