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Can perpetual learning explain the forward-premium puzzle?

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  • Chakraborty, Avik
  • Evans, George W.

Abstract

Under rational expectations and risk neutrality the linear projection of exchange-rate change on the forward premium has a unit coefficient. However, empirical estimates of this coefficient are significantly less than one and often negative. We show that replacing rational expectations by discounted least-squares (or "perpetual") learning generates a negative bias that becomes strongest when the fundamentals are strongly persistent, i.e. close to a random walk. Perpetual learning can explain the forward-premium puzzle while simultaneously replicating other features of the data, including positive serial correlation of the forward premium and disappearance of the anomaly in other forms of the test.

Suggested Citation

  • Chakraborty, Avik & Evans, George W., 2008. "Can perpetual learning explain the forward-premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 477-490, April.
  • Handle: RePEc:eee:moneco:v:55:y:2008:i:3:p:477-490
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    JEL classification:

    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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