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Investor Overconfidence and the Forward Discount Puzzle

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  • Han, Bing
  • Hirshleifer, David
  • Wang, Tracy

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

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Cited by:
  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.
  2. Jylhä, Petri & Suominen, Matti, 2011. "Speculative capital and currency carry trades," Journal of Financial Economics, Elsevier, Elsevier, vol. 99(1), pages 60-75, January.

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