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Home Bias in Currency Forecasts

  • Yu-chin Chen
  • Kwok Ping Tsang
  • Wen Jen Tsay

The "home bias" phenomenon states that empirically, economic agents often under- utilize opportunities beyond their country borders, and it is well-documented in various international pricing and purchase patterns. This bias manifests in the forms of fewer exchanges of goods and net equity-holdings, as well as less arbitrage of price differences across borders than theoretically predicted to be optimal. Our paper documents another form of home bias, where market participants appear to under-weigh information beyond their borders when making currency forecasts. Using monthly data from 1995 to 2010 for seven major exchange rates relative to the US dollar, we show that excess currency returns and the errors in investors' consensus forecasts not only depend on the interest differentials between the pair of countries, but they depend more strongly on interest rates in a broader set of countries. A global short interest differential and a global long interest differential are driving the results.

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File URL: ftp://repec.econ.vt.edu/Papers/Salehi-Isfahani/ReturnsEducation.pdf
File Function: First version, 2010
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Paper provided by Virginia Polytechnic Institute and State University, Department of Economics in its series Working Papers with number e07-18.

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Length: 37 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:vpi:wpaper:e07-18
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  1. Djavad Salehi-Isfahani, 2007. "Poverty, Inequality, and Populist Politics in Iran," Working Papers e07-1, Virginia Polytechnic Institute and State University, Department of Economics.
  2. Charles Engel & Nelson C. Mark & Kenneth D. West, 2007. "Exchange Rate Models Are Not as Bad as You Think," NBER Working Papers 13318, National Bureau of Economic Research, Inc.
  3. Mark W. Watson & James H. Stock, 2004. "Combination forecasts of output growth in a seven-country data set," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 23(6), pages 405-430.
  4. Yu-chin Chen & Kwok Ping Tsang, 2010. "A Macro-Finance Approach to Exchange Rate Determination," Working Papers e07-19, Virginia Polytechnic Institute and State University, Department of Economics.
  5. Yu-chin Chen & Kwok Ping Tsang, 2010. "What Does the Yield Curve Tell Us about Exchange Rate Predictability?," Working Papers 292010, Hong Kong Institute for Monetary Research.
  6. Timmermann, Allan G, 2005. "Forecast Combinations," CEPR Discussion Papers 5361, C.E.P.R. Discussion Papers.
  7. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  8. Froot, Kenneth A & Frankel, Jeffrey A, 1989. "Forward Discount Bias: Is It an Exchange Risk Premium?," The Quarterly Journal of Economics, MIT Press, vol. 104(1), pages 139-61, February.
  9. Djavad Salehi-Isfahani & Daniel Egel, 2007. "Youth Exclusion in Iran: The State of Education, Employment and Family Formation," Working Papers e07-2, Virginia Polytechnic Institute and State University, Department of Economics.
  10. Hanno Lustig & Adrien Verdelhan, 2007. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk," American Economic Review, American Economic Association, vol. 97(1), pages 89-117, March.
  11. Gourinchas, Pierre-Olivier & Tornell, Aaron, 2004. "Exchange rate puzzles and distorted beliefs," Journal of International Economics, Elsevier, vol. 64(2), pages 303-333, December.
  12. Michael B. Devereux & Gregor W. Smith & James Yetman, 2009. "Consumption and Real Exchange Rates in Professional Forecasts," NBER Working Papers 14795, National Bureau of Economic Research, Inc.
  13. Xavier Sala-I-Martin & Gernot Doppelhofer & Ronald I. Miller, 2004. "Determinants of Long-Term Growth: A Bayesian Averaging of Classical Estimates (BACE) Approach," American Economic Review, American Economic Association, vol. 94(4), pages 813-835, September.
  14. Isiklar, Gultekin & Lahiri, Kajal & Loungani, Prakash, 2006. "How quickly do forecasters incorporate news? Evidence from cross-country surveys," MPRA Paper 22065, University Library of Munich, Germany.
  15. Emmanuel Farhi, 2008. "Rare Disasters and Exchange Rates," 2008 Meeting Papers 47, Society for Economic Dynamics.
  16. Monika Piazzesi & Martin Schneider, 2009. "Trend and cycle in bond premia," Staff Report 424, Federal Reserve Bank of Minneapolis.
  17. Fatma El-Hamidi, 2006. "General or Vocational Schooling? Evidence on School Choice, Returns, and 'Sheepskin' Effects from Egypt 1998," Journal of Economic Policy Reform, Taylor & Francis Journals, vol. 9(2), pages 157-176.
  18. Philippe Bacchetta & Elmar Mertens & Eric van Wincoop, 2006. "Predictability in Financial Markets: What Do Survey Expectations Tell Us?," Working Papers 06.04, Swiss National Bank, Study Center Gerzensee.
  19. Farhi, Emmanuel & Gabaix, Xavier, 2015. "Rare Disasters and Exchange Rates," CEPR Discussion Papers 10334, C.E.P.R. Discussion Papers.
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