Journal Article

Investor Overconfidence and the Forward Premium Puzzle

Craig Burnside, Bing Han, David Hirshleifer and Tracy Yue Wang

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 78, issue 2, pages 523-558
Published in print April 2011 | ISSN: 0034-6527
Published online February 2011 | e-ISSN: 1467-937X | DOI: https://dx.doi.org/10.1093/restud/rdq013
Investor Overconfidence and the Forward Premium Puzzle

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  • International Financial Markets
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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.

Keywords: Investor overconfidence; Exchange rates; Forward bias; Carry trade; PPP; Money supply; Monetary policy; F31; G12; G14; G15

Journal Article.  15013 words.  Illustrated.

Subjects: International Financial Markets ; Economics ; International Finance

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