Working Paper: CEPR ID: DP3725
Authors: Pierre-Olivier Gourinchas; Aaron Tornell
Abstract: We propose a new explanation for the forward-premium and the delayed-overshooting puzzles. Both puzzles arise from a systematic under-reaction of short-term interest rate forecasts to current innovations. Accordingly, the forward premium is always a biased predictor of future depreciation; the bias can be so severe as to lead to negative coefficients in the ?Fama? regression; delayed overshooting may or may not occur depending upon the persistence of interest rate innovations and the degree of under-reaction; lastly, for G-7 countries against the US, these puzzles can be rationalized for values of the model's parameters that match empirical estimates.
Keywords: Delayed Overshooting; Forward-Premium Puzzle; Monetary Policy; Predictable Returns
JEL Codes: E40; F31; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| systematic underreaction of short-term interest rate forecasts (E47) | forward premium is a biased predictor of future depreciation (F31) |
| misperception about the nature of interest rate shocks (E43) | predictable excess returns (G17) |
| interest rate forecasts (E47) | exchange rate dynamics (F31) |
| persistence of interest rate innovations (E43) | delayed overshooting (C69) |
| learning about interest rate shocks (E43) | observed dynamics (C69) |