Working Paper: NBER ID: w15866
Authors: Craig Burnside; Bing Han; David Hirshleifer; Tracy Yue Wang
Abstract: 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 behavior of forward and spot exchange rates. Our approach is also consistent with the availability of profitable carry trade strategies.
Keywords: Investor Overconfidence; Forward Premium Puzzle; Foreign Exchange Markets; Carry Trade Strategies
JEL Codes: F31; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Overconfident investors (G41) | overreact to information about future inflation (E31) |
| Overreaction to information about future inflation (E31) | greater overshooting in the forward rate compared to the spot rate (E43) |
| Rise in the forward premium (F31) | subsequent downward correction in the spot rate (E43) |
| Overreaction of the forward rate to inflation signals (E31) | negative correlation with future exchange rate changes (F31) |
| Forward premium (G13) | predictor of future exchange rate corrections (F31) |
| Professional forecast errors in currency markets (F37) | negatively correlated with the forward premium (F31) |