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A sentiment-based explanation of the forward premium puzzle

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  • Jianfeng Yu
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    Abstract

    This paper presents a sentiment-based explanation of the forward premium puzzle. Agents over- or underestimate the growth rate of the economy. All else equal, when perceived domestic growth is higher than perceived foreign growth, the domestic interest rate is higher than the foreign interest rate. At the same time, an econometrician would expect an increase in the home currency value. Together, the model with investor misperception can account for the forward premium puzzle.> ; In addition, it helps explain the low correlation of consumption growth differentials and exchange rate growth and the high stock market correlation across countries, despite a low correlation of fundamentals. Finally, this paper provides direct empirical evidence supporting the mechanism in the sentiment-based explanation.

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    File URL: http://www.dallasfed.org/assets/documents/institute/wpapers/2011/0090.pdf
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    Bibliographic Info

    Paper provided by Federal Reserve Bank of Dallas in its series Globalization and Monetary Policy Institute Working Paper with number 90.

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    Date of creation: 2011
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    Handle: RePEc:fip:feddgw:90

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    Keywords: Asset pricing ; Foreign exchange ; Financial markets;

    This paper has been announced in the following NEP Reports:

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    Cited by:
    1. 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.
    2. 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.

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