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A sentiment-based explanation of the forward premium puzzle

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  • Yu, Jianfeng

Abstract

A sentiment-based model of the exchange rate is proposed to understand the forward premium puzzle. Agents over- or under-estimate 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, misperception helps lower the correlation between consumption growth differentials and exchange rate growth. Finally, this paper provides empirical evidence supporting the mechanism in the sentiment-based explanation.

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  • Yu, Jianfeng, 2013. "A sentiment-based explanation of the forward premium puzzle," Journal of Monetary Economics, Elsevier, vol. 60(4), pages 474-491.
  • Handle: RePEc:eee:moneco:v:60:y:2013:i:4:p:474-491
    DOI: 10.1016/j.jmoneco.2013.04.001
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    12. Michael Jetter & Alex Nikolsko-Rzhevskyy & Olena Ogrokhina, 2019. "Can policy shifts explain the forward discount puzzle?," Empirical Economics, Springer, vol. 57(6), pages 1891-1909, December.
    13. Guofu Zhou, 2018. "Measuring Investor Sentiment," Annual Review of Financial Economics, Annual Reviews, vol. 10(1), pages 239-259, November.
    14. Lansing, Kevin J. & Ma, Jun, 2017. "Explaining exchange rate anomalies in a model with Taylor-rule fundamentals and consistent expectations," Journal of International Money and Finance, Elsevier, vol. 70(C), pages 62-87.
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