Investor overconfidence and the forward premium puzzle

Burnside, C. , Han, B., Hirshleifer, D. and Wang, T.Y. (2011) Investor overconfidence and the forward premium puzzle. Review of Economic Studies, 78(2), pp. 523-558. (doi: 10.1093/restud/rdq013)

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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.

Item Type:Articles
Glasgow Author(s) Enlighten ID:Burnside, Professor Craig
Authors: Burnside, C., Han, B., Hirshleifer, D., and Wang, T.Y.
Subjects:H Social Sciences > HB Economic Theory
H Social Sciences > HG Finance
College/School:College of Social Sciences > Adam Smith Business School > Economics
Journal Name:Review of Economic Studies
ISSN (Online):1467-937X
Published Online:03 February 2011

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