Journal
REVIEW OF ECONOMIC STUDIES
Volume 78, Issue 2, Pages 523-558Publisher
OXFORD UNIV PRESS
DOI: 10.1093/restud/rdq013
Keywords
Investor overconfidence; Exchange rates; Forward bias; Carry trade; PPP; Money supply; Monetary policy; F31; G12; G14; G15
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We offer an explanation for the forward premium puzzle in foreign exchange markets based upon investor overconfidence. In the model, overconfident individuals overreact to their information about future inflation, which causes greater overshooting in the forward rate than in the spot rate. Thus, when agents observe a signal of higher future inflation, the consequent rise in the forward premium predicts a subsequent downward correction of the spot rate. The model can explain the magnitude of the forward premium bias and several other stylized facts related to the joint behaviour of forward and spot exchange rates. Our approach is also consistent with the availability of profitable carry trade strategies.
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