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Investor Overconfidence and the Forward Discount Puzzle

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Author Info
Han, Bing
Hirshleifer, David
Wang, Tracy

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Abstract

This paper offers an explanation for the forward discount puzzle in foreign exchange markets based upon investor overconfidence. In our model, overconfident individuals overreact to their information about future inflation differential. The spot and the forward exchange rates differentially reflect such overreaction; as a result, the forward discount forecasts reversal in the spot rate. With plausible parameter values, the model explains the magnitude of the forward discount puzzle and stylized facts about how the forward discount bias varies with time horizon and time-series versus cross-sectional test method. Furthermore, the model generates new empirical predictions about the relation between the forward discount bias to foreign exchange trading volume, exchange rate volatility and predictability, as well as the degree of violation of the relative Purchasing Power Parity.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 6497.

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Date of creation: Jun 2005
Date of revision: Dec 2007
Handle: RePEc:pra:mprapa:6497

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Related research
Keywords: Uncovered Interest Parity forward discount puzzle inflation differential investor overconfidence exchange rate overshooting market efficiency Purchasing Power Parity.

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Find related papers by JEL classification:
G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
G15 - Financial Economics - - General Financial Markets - - - International Financial Markets
F31 - International Economics - - International Finance - - - Foreign Exchange

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References listed on IDEAS
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Craig Burnside & Martin S. Eichenbaum & Sergio Rebelo, 2007. "Understanding the Forward Premium Puzzle: A Microstructure Approach," NBER Working Papers 13278, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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